Thursday, December 30, 2004

How High?
Although the price of West Texas Intermediate crude oil (WTI) may be the most frequently reported indicator of the oil market, it is not necessarily the best measure. Most oil trades at a discount to WTI, because of quality, location, or timing. But for looking at big trends and market shifts, the WTI market, and specifically the WTI futures contract on the New York Mercantile Exchange, has the advantage of being highly transparent and liquid. And what a story it tells for 2004!

WTI started the year $9 lower than it is today, at a level that many thought was already quite steep, reflecting problems in Iraq and other producing countries. In fact, the average for 2004 will be more than $10 per barrel higher than for 2003, which itself was nearly $5 higher than for 2002. Even ignoring the $55 peak in October of this year, oil is up about $15 in the last two years, putting it about that much above the long-term average price in nominal dollars. So is this an anomaly, or a trend that we should expect to persist?

Here are some of the issues that support the idea of persistent higher-than-normal prices:
  • Demand has grown faster than expected, largely driven by China and other Asian markets.
  • Many key producers continue to experience shortfalls due to weather, labor unrest, politics, and a host of other factors.
  • Mature areas such as the North Sea and North Slope are in decline.
  • The reserve base of the major oil companies looks less secure than in the past, partly for accounting reasons, but more importantly due to constraints on access.
  • OPEC is enjoying huge revenues, most of which are needed to alleviate domestic social problems.
But on the other hand:
  • The global economy is expected to slow somewhat next year.
  • Inventories in consuming countries are growing, indicating slower demand.
  • New production will be coming onstream in West Africa and Russia.
  • Many speculators have reduced their exposure to oil.
  • The market has a long history of reverting to the average, despite countless projections for continued increases.

When I tally up all of these factors, I see enough constraints to keep prices above the long-term average for the next year or two, but not enough to keep it at quite today's level, barring another crisis. OPEC's discipline in cutting production to prevent an inventory bubble will get a real test if this winter continues to be mild. So when I look at the NYMEX futures market's price for delivery in December 2005 of $41, I don't see a forecast of stability, but rather a market that is probably just playing it safe and might rather wish to bet that the price will be either $30-35, or over $50, depending on world events.

Wednesday, December 29, 2004

Hybrid Reality
Catching up on my reading from Christmas week I ran across this article in the New York Times, reporting some disappointing results from GM's hybrid buses. As the official from the American Public Transit Association indicated, hybrids offer more benefits than just fuel economy, including acceleration and reduced emissions. Still, it is apparent that the actual fuel savings achieved, just like those on conventional vehicles, vary widely with driving patterns. In particular, hybrids provide the greatest benefit when they are used in urban, stop-and-go traffic, and much less on the open road. This is something that anyone considering buying a Toyota Prius or Honda hybrid should remember, too.

The other interesting element in this story is the strategy behind GM's entry into the hybrid bus segment, based on the assumption that these vehicles' heavy use patterns makes them ideal for hybridization. I've heard the same rationale for targeting buses and trucks for early fuel cell applications. But targeting the right subset of this segment will be critical, to maximize the benefits of hybrids or fuel cells. Developers must also consider all the attributes that customers care about, not just fuel economy. GM's experience with hybrid buses shouldn't be seen as a setback, but rather as a learning opportunity.

Tuesday, December 28, 2004

Tsunami Aftermath
The scale and breadth of the human tragedy from this disaster simply boggle the mind. Although small consolation to those grieving lost relatives, it appears that the region's energy infrastructure escaped major damage, including the major oil and liquefied natural gas production facilities on Sumatra, near the epicenter of the quake that triggered the tsunamis. Nor have I seen any reports of damage to the refineries in the region, including Thailand's substantial refining industry on its southern coast. Both in economic and practical terms, these facilities will be critical in supporting the reconstruction that must begin shortly.

Now I can only wonder about the fate of the many fine people I met over the years, both in my travels in Southeast Asia and here.

Tuesday, December 21, 2004

Energy Independence?
Yesterday's Wall Street Journal carried a guest editorial (subscription required) by Robert MacFarlane, former national security advisor to President Reagan, on the theme of energy independence. Citing Amory Lovins' latest book, "Winning the Oil Endgame," (see my posting of September 29) he indicated that not only greater energy security, but actual energy independence could be achieved within 35 years. Is this possible or even desirable?

The idea of energy independence grew out of the two oil shocks of the 1970s. Technology has advanced sufficiently since then for us at least to paint a picture of what an energy-independent US might look like, and the changes this would require. Dr. Lovins' view is as good an attempt at that as any, though it is not the only possible version of independence. But having the technology and making it happen are two different things. We have the technology to return to the moon, even if that meant using the same methods as the first time, but does that mean we will go anytime soon? If $50 oil doesn't galvanize an effort for a radical change in our approach to energy, then we are probably looking at the entire problem the wrong way.

Further, even if Dr. Lovins' figures are correct in terms of the amount of investment required to replace key portions of our energy and automotive infrastructure, is this the best use of that capital? The market alone will not deliver such a change on anything like the timetable suggested by Mr. MacFarlane. Although this may well be one of those areas in which the market doesn't send the right signals far enough in advance, going against it requires some caution. Pushing ahead to have these conversions in place by 2040 requires choosing technology winners and losers now or in the near future. Our track record in that area is not very good.

Finally, we need a genuine consensus on the criteria for making these choices. For example, is it only a question of energy independence, which might be met entirely with coal, or rather of clean energy independence? If the latter, is clean limited to local pollutants, or does it include greenhouse gases? No consensus on these issues exists today, and these distinctions have major practical implications for the path we would choose. The debate highlights the need for a real energy policy for the country, and for a different way to go about arriving at one.

I've never thought that energy independence was the right goal, as appealing as it might sound, any more than we should be textile-independent or knowledge-independent. Energy independence is a 20th century notion that translates poorly into an increasingly globalized 21st century. Instead, being smarter about energy--whether foreign or domestic--has a higher chance of leading us down the right path and improving not just our energy security, but our entire economic well-being. That means reexamining and reengineering our entire energy ruleset, for starters, and giving businesses the right incentives and tools to provide reliable, safe and clean energy, with less disruptive price volatility.

Monday, December 20, 2004

The Changing Future of Energy
As we approach the end of the year, it's appropriate to think about how our picture of the energy future has changed in the last twelve months. Here are some thoughts, in no particular order:

  • OPEC still matters, if only as a constraint on Saudi Arabia, which left to its own devices might choose to produce at much higher levels. Nor is there any visible sign that the Kingdom intends to offer the international oil companies access to its undeveloped reserves, despite a growing chorus in the industry that this will be necessary to meet future demand.
  • Thanks to the insurgency's calculated attacks on contractors and the generally poor security environment, development of Iraq's hundred billion plus barrels of oil may be delayed for years. More new oil will probably flow out of Libya than Iraq in the next five years.
  • The future of the most promising non-OPEC producer, Russia, is now under a cloud. At this point we don't even know the identity of the winner of the auction for Yukos's largest subsidiary.
  • Although nearly everyone now realizes the necessity for importing large quantities of LNG into the US to prevent a serious shortfall of natural gas supply, most of the proposed import terminal locations face uphill--if not entirely futile--battles for approval.
  • Hybrid cars have gone from a novelty driven by Toyota to a mainstream trend that all the carmakers are rushing to follow.
  • Climate change looms as yet another EU/US political crisis, thanks to our apparent unwillingness even to engage in a reasonable conversation on the subject.
  • While fuel cell vehicles may look even further off than they did a year ago, small fuel cells are going to start turning up in consumer devices, raising at least awareness of the technology.

The biggest surprise for me in 2004 is that we could see $50/barrel oil and end the year with oil and natural gas prices roughly double their long-term averages (in nominal dollars) without seeing any consequences more serious than a lot of complaining. Are energy issues simply trumped by security concerns in the post-9/11 world, or are we really that confident that the market will deliver the energy supplies we need?

My blogging is going to be a lot more sporadic over the next week, as the holidays approach, but I'll be on the alert for any news the really demands comment.

Friday, December 17, 2004

A Friendlier Venue
It's not terribly surprising that Yukos was able to find a court in Texas willing to involve itself in the battle over its dismemberment, even though a couple of years ago Yukos convinced another Texas court that it didn't have enough activities in the state to be sued there.

At this stage, it appears that the goal of Yukos's management-in-exile has shifted from preventing the sale of their largest subsidiary--which appears to be a foregone conclusion--to making it as politically costly as possible for President Putin. Taken together with Russia's heavy-handed, unsuccessful meddling in Ukraine's recent election, this has produced the worst patch in US/Russia relations since the collapse of the USSR.

At the end of the day, though, too much of Russia's financial future is bound up in trade--especially mutually-beneficial energy trade--with the EU and US for the rift to be allowed to worsen and become permanent. The outcome is uncertain, but pragmatism should still win out over pride to keep Russia at least nominally in the Western camp, rather than striking out entirely on its own, again.

Thursday, December 16, 2004

The Real "New World Order"
I see that Unocal has settled the case against it relating to human rights in Burma. Unocal was charged with complicity with the government of Burma in various human rights violations related to the construction of a gas pipeline in that country. Although its not clear how much precedent an out-of-court settlement creates for this kind of application of the Alien Tort Claims Act of 1789, the implications for businesses, either US-based or with significant US operations, seem pretty clear.

For some time various non-governmental organizations (NGOs) have pushed for the application of US standards in labor practices, safety, and environmental protection on companies operating outside the US. One case doesn't make a trend, but prudent managers and investors should expect wider and more frequent use of this approach in the future. The rise of global "civil society", in the form of influential NGOs with both media and legal savvy, is one of the major developments of the last decade or so.

On one level, companies operating abroad will need to do so to the higher of US or local standards. But, as in the Unocal case, the greater peril may come from the actions of local partners, including governments, that are not under the control of the US entity, but for whose actions the US firm may be held responsible. Fair or not, this raises the stakes significantly when considering whether an opportunity in a country with a less-than-perfect government, or less-than-ideal commercial partners, may be attractive enough to offset the financial and reputational risks involved. It also suggests that companies need to build up positive "soft power" in form of relationships with NGOs and multi-lateral agencies.

Wednesday, December 15, 2004

The Big Sucking Sound
The finances of the big national oil companies aren't usually very transparent. If the picture of Pemex, Mexico's state oil company, in the current Business Week article (site registration may be required) is representative of its counterparts in other key producing countries, there could be serious trouble ahead. These companies have monopolies over the most productive oil resources on the planet, along with the lion's share of the world's untapped oil reserves. If they cannot generate the capital to develop these reserves in a timely manner, then the world's oil pipeline has a great big slug of air coming our way, somewhere in the 5-10 year timeframe.

Pemex's balance sheet is shaky because of a phenomenon we also see in the Middle East and Venezuela: it is easier for these governments to dole out oil industry profits for social welfare and infrastructure projects than to tax their citizens. But even in countries blessed with huge oil endowments, some level of reinvestment is essential to keep oil reservoirs healthy and to sustain future production. The worst example is in Iraq, where the fall of the Ba'ath regime exposed a decade of starvation diets for both the oilfields and oil infrastructure, with Oil-for-Food money skimmed off to build palaces and missiles.

A growing industry chorus is calling for the producing countries to provide commercial access to their resources to the international oil companies, which have the best technology for managing them. But a side benefit might be improved governance that would treat reinvestment as a priority and withhold these funds from remittances to the state. This would benefit all parties in the long run, by improving the stewardship of these resources.

Tuesday, December 14, 2004

Not Quite Ready for Prime Time
Developers of fuel cell vehicles (FCVs) face some basic challenges in preparing their prototypes to handle the extremes of winter, as highlighted in this recent article in the Automobile section of the Sunday New York Times. The primary concern is that the membranes in a polymer-type fuel cell can be damaged if the water in the cell freezes, and carmakers are having to find some clever workarounds. By itself, though, no one should see this as an insurmountable obstacle to fuel cell vehicle adoption, unless the overall performance of these cars remains inferior to that of internal combustion powered cars.

You'd have to be in your nineties to remember when early piston-engine automobiles suffered from similar problems. Modern radiator anti-freeze only dates back to the 1930s, and prior to that, motorists either had to keep their cars above freezing or use methanol in the radiator, which created other problems. People continued to buy early cars in spite of limitations that we would now find totally unacceptable, because cars represented such an improvement, and because owning one was considered cool (or hep or whatever the term would have been.)

Unfortunately for FCV developers, the competition isn't horses and trolleys, but engine technology that has been refined continuously for a century to a high degree of reliability and performance. Hybrids raise the competitive bar even higher, by delivering fuel economy that approaches that of an FCV, with technology that is less radical and--at least today--perceived as more reliable.

Aside from all the other impediments to rapid commercialization of FCVs, such as infrastructure availability, hydrogen supply, and the high cost of fuel cell stacks (all of which are very big issues), I still think the key will be consumer acceptance. Will there will be enough early adopters prepared to take a step or two backwards on convenience and reliability to get the next "great leap forward"? You can bet carmakers are paying extremely close attention to the profiles and demographics of the folks buying hybrids today.

Monday, December 13, 2004

Deliberately Obtuse?
Today's lead editorial in the Wall St. Journal (subscription required) is entitled "Kyoto Capitalists". It criticizes firms such as Cinergy (see my blog of December 7, by scrolling down this page) for committing to reduce greenhouse gas emissions, on the grounds that these reductions are motivated by a thirst for profits, and that they will be too small to prevent global warming in any case. Along the way, the Journal displays a fundamental misunderstanding of the chemistry behind greenhouse gas emissions. While I often find the Journal's views compelling and well-reasoned, their arguments here seem mostly mean-spirited and wrong-headed.

Let's start with the profit motive. In fact, the whole impetus behind market-based emissions reduction tools, such as cap-and-trade and the Clean Development Mechanism built into the Kyoto Treaty is that more reductions will be achieved if they benefit the parties making them. This used to be called "doing well while doing good." So of course companies like Cinergy want to make reductions in the most profitable way possible. The Journal's assessment that these profits will come out of the hide of consumers and taxpayers is no more or less true than for any other type of profit. The real issue is whether the economic activity associated with greenhouse gas reductions is a zero-sum game or an increasing-pie game, and I see no inherent reason why it must be the former and not the latter.

Another charge the Journal levels at these companies is that they are seeking to get paid for greenhouse gas reductions that will happen anyway, as a consequence of meeting stricter rules on emissions of sulfur and nitrogen compounds. This may be true to a small extent, but it misses the basic distinction between sulfate and nitrate pollution and the emission of CO2 and other greenhouse gases. The former results from either fuel impurities (sulfur) or the amount of nitrogen present when combustion takes place. This pollution can be managed with a variety of strategies, including fuel treatment, stack gas scrubbing, lean burning, and oxygen-firing. But CO2 emissions are not pollution; they are the principal product of combustion, along with water vapor. Reducing them significantly means either using much less fuel in the first place, or separating CO2 from exhaust gases and storing it underground. Either approach requires not just a little scrubbing and tweaking, but a major redesign of process hardware, at enormous cost. The alternative is buying reductions from other sectors of the economy that can make them more cheaply, and that is the whole point of cap-and-trade.

Ultimately, the Journal's sarcasm reflects their skepticism that climate change is real. While this is still a legitimate viewpoint, it is increasingly out of step with mounting evidence to the contrary. But even if one remains skeptical, the potential consequences of global warming are serious enough that they justify buying some insurance, and I believe that is precisely what the companies in question are wisely doing. Whether their actions will matter in the event of major climate change is really beside the point. Action must begin somewhere, if it is to happen at all. For the rest of the developed world, like it or not, that start is the Kyoto Treaty and its modest emissions reductions, as a downpayment on broader and deeper cuts later.

Friday, December 10, 2004

The Future of Oil Companies
A couple of weeks ago I wrote about some of the changes taking place in the international oil industry, describing them as a of realignment of ecological niches. (See postings of Nov. 17 & 18.) Yesterday's Financial Times included a truly insightful article that probed these issues in much greater detail, using the opening of new exploration and production opportunities in Libya as a case in point. Anyone interested in the oil industry, whether as an investor, supplier, or employee, should give some thought to the issues the authors raise. The outcome will determine the nature and profitability of the major oil companies for the next ten to twenty years.

If you look at the oil business in purely economic terms, there are three principal sources of value associated with petroleum. (The analysis is similar, but slightly different for natural gas.) First, there is the value created by finding oil, taking it from the earth and bringing it to market. This corresponds to the "upstream" portion of the industry. The second portion covers the "midstream" and "downstream", in which the oil is transported, refined, and the resulting products sold. Finally, there's the value created through the use of the products, including transportation and the petrochemicals.

Despite massive investments in refineries and highly visible service station networks, most of the economic value of the international oil majors, for most of their history, has come from the Upstream, through their ability to capture part of the economic "rent" on oil production. What makes the issues raised in the FT article so challenging is that they threaten to dry up the companies' access not only to new oil and gas reserves, but more fundamentally to the gusher of above-average returns--the "rent"--derived from them.

To understand how this works, compare an oil field in the North Sea to one in Kuwait. In the former case, the company producing the oil paid for an exploration concession, invested in finding and developing the oil, and now enjoys the full value of the production stream, less operating costs, taxes and royalties. In Kuwait, on the other hand, the state oil company may hire one of the majors or service companies to perform work on a field, but only pays them a fee for the work. The state oil company keeps essentially 100% of the uplift between the cost of production and the market price. The worst-case scenario for the majors is a world in which all the future production opportunities look like Kuwait, and none look like the North Sea.

While that may be an unlikely outcome, the threat of the cost of production sharing contracts and concessions being bid up by new competitors to levels that leave little room for upstream profitability by the majors is not. Nor is it hard to imagine more and more of these deals being done preferentially between state oil companies, leaving little role for the majors.

None of this is new. Some companies have seen these possibilities for at least a decade. What is not apparent, however, is the kind of transformed oil company value proposition that would be required to carve out an advantaged and highly profitable niche in such a world. To find that, as the article suggests, the companies must have a very clear idea of what they bring to the table, and with today's global markets for capital, it can't just be money.

What can the likes of ExxonMobil, BP, Shell, ChevronTexaco and their smaller brethren offer that a Sinopec or Petrobras--or an alliance between a hedge fund and a service provider--can't compete with? The answer to that question will end up being the majors' dominant business model for the next couple of decades, unless they want to treat their upstream businesses as depleting cash cows from which to fund other activities.

Thursday, December 09, 2004

Very Stationary Sources
Vehicles get an awful lot of the attention when it comes to improving energy efficiency and reducing emissions of local pollutants and greenhouse gases. This is natural, since their inputs and outputs are part of our daily experience of life. But as this interesting article from last week's Economist points out, energy efficient buildings represent a tremendous opportunity to cut energy use and pollution, as well as providing many other benefits.

The statistics are impressive. According to the article, buildings in the US account for roughly a third of total energy use and greenhouse gas emissions, and nearly two thirds of electricity consumption. The most efficient buildings appear to be 1/3 to half again more efficient than the average. Multiplied across the entire economy, the potential savings could be comparable to increasing the market share of hybrid cars to half of new car sales in 10 years.

The key strategies for achieving these savings include the use of new building materials, better insulation, more use of natural light, and some degree of onsite power generation from wind, solar, or fuel cells. Less obvious but just as dramatic is the benefit of computer modeling during design to understand how a building interacts with its surroundings, and to optimize these relationships.

The most encouraging thing here is that this seems to be an architectural movement driven by economics, rather than aesthetics, and should thus be more sustainable. Even if oil and gas prices reverted to their historical averages--something that looks like a dim prospect anytime soon, especially for gas--there are big dollars driving these innovations. To my tastes, a side benefit is that these buildings aren't just high tech, but they look it, too. You can regard them as anything from odd to cool, but boring they're not.

Wednesday, December 08, 2004

A Cheaper Alternative to Fuel Cells?
For the past several years I've been intrigued by the potential of fuel cells for home power generation and incidental water heating. There are already several prototypes on the market, such as those from Plug Power. But now there's a lower-tech version of the same idea: a natural gas-fired home generator that can run a circulating hot water heating system and put out 1200 watts of electricity. It's powered by a Stirling engine, which until recently has been a novelty device, but was always seen on the verge of a big breakthrough.

The WhisperGen, built in New Zealand, is on initial home trials in the UK, at a cost of 1350 pounds sterling ($2600 at current exchange rates.) It could give home fuel cells serious competition on two fronts. First, it is billed as a boiler that also generates electricity, rather than as a generator that incidentally produces some hot water, so consumers may regard it as more similar to existing home heating systems. Secondly, although the Stirling engine is not exactly a familiar item, it is still less exotic--and perhaps more reliable-sounding--than a fuel cell.

At the end of the day, I suspect that a little competition in this area will turn out to be healthy for both technologies, since at this point the success of both relies on changing consumers' perceptions about producing electricity in the home, rather than relying exclusively on the power grid.

Tuesday, December 07, 2004

Reducing Uncertainty
Risk and uncertainty are the bane of market value, when they can't be managed effectively. With respect to climate change, some companies seem to be coming around to the idea that setting limits on emissions and relying on market mechanisms to implement them is preferable to the risk of a patchwork of state-by-state regulation of greenhouse gas emissions--perhaps similar to our balkanized gasoline specifications--or of a more onerous national program that might follow a future crisis. The publication of a report on greenhouse emissions by Cinergy, a midwestern utility, affirms this view.

Their report may not come as a surprise, since Cinergy was already a member of the Pew Center on Climate Change, an industry group that supports proactive measures to address global warming. But it is sobering, given the assessment that complying with proposed reductions could cost Cinergy up to $2 billion over 10 years, because of its reliance on coal-fired power generation. That suggests that Cinergy's executives believe it is better for their shareholders to define the risk, even if managing it costs real money, rather than leaving it as a gaping uncertainty overshadowing the firm's value.

In this light, the Administration's position on the Kyoto Treaty--reiterated at the Conference of the Parties (COP-10) in Argentina--can only be viewed as counterproductive. It may actually be damaging US business interests, at least in terms of their market value, well in excess of the estimated cost of compliance.

Monday, December 06, 2004

Apollo for Energy
In his Sunday New York Times column, Tom Friedman made a strong case for an Apollo Program for energy, to make the US independent of foreign oil suppliers. Aside from the geopolitical benefits that would accrue, such an effort would presumably create lots of jobs in this country, and perhaps whole new industries. Is this feasible and practical, or is it an unattainable dream?

Just to set a baseline, the cost of the Apollo Program, adjusted for inflation, was roughly $170 billion, including all R&D and procurement. By comparison, Canada will spend about C$25 million to add one million barrels per day of synthetic oil production over the next decade (see my blog of September 23). The US today imports ten times that much oil. This suggests that Apollo is probably the right cost ballpark, though it does not tell us which path to pursue.

There are two broad, distinct strategies for getting there, each with very different paths and implications, and requiring different combinations of research, infrastructure, demonstration facilities, and incentives. The first would involve the production of substitute fuels that are compatible with our existing transportation energy system. That might include biofuels, such as alcohol or biodiesel, or synthetic oil from other hydrocarbon sources, such as coal, oil shale, or natural gas. This option would be mostly a matter of improving current processes, then embarking on a massive construction spree.

The other major alternative entails creating an entirely new energy system, along the lines envisioned for a hydrogen-based economy. This would require much more upfront R&D, construction of new, parallel infrastructure and, in the case of hydrogen or a similar energy carrier, a major increase in primary energy production. That could take the form of a vast expansion of renewable energy, new nuclear plants, or even new coal-fired power plants.

Without delving any further, the cost of the latter approach would clearly be much larger, and the transition period longer than for a synthetic hydrocarbon fuels program, because it would require so much new hardware. The timing and total cost are also much more uncertain, because they hinge on breakthroughs or major technology improvements that haven't yet occurred.

Choosing between these different strategies also takes us beyond the realm of energy security and into global environmental and industrial policy. For example, how important is it that the result be "carbon neutral", to avoid contributing to further greenhouse gas emissions? Are we just trying to back out oil imports, or do we want to transform the whole US energy economy? The more ambitious our goal, the longer it will take and the riskier the path will be.

The good news is that in either case the cost of oil imports should start to come down long before the final result was in place. The market would begin to discount the price of oil as soon as the tangible proof of our commitment--people and investment dollars--was in place. And oil producers with long-lived reserves, such as the Saudis, would likely react by bringing lots of production on quickly and flooding the market, to try to make our alternatives uneconomical. That alone would go a long way toward achieving Mr. Friedman's goals.

Unfortunately, although I think it's truly possible to mount an Apollo-like effort for energy, I just don't see the will to do it. If an election held against the backdrop of $50 oil wasn't sufficient to focus our attention on this issue, what would be? I also question whether such an approach would produce the best answer, since it would require making some irreversible choices early on. A less ambitious but still significant increase in energy R&D--both public and private--plus some X-Prize-like incentives for key technology milestones might not give us energy independence in ten years, but it could provide a range of great new options in surprising areas and lay the groundwork for a viable, sustainable energy future.

Friday, December 03, 2004

When Is Risk Management Not?
I don't know how much I can add to what's being said about the problems of China Aviation Oil, a Singapore-based petroleum products trading company that has run up derivatives losses on jet fuel of around a half billion dollars in the last several months. The situation is being called everything from the result of a rogue trader to a warning about the governance of Chinese corporations. At a minimum, it serves as another cautionary tale on the need for absolute discipline in the area of price risk management.

We used to call this stuff hedging, until the proliferation of new tools such as options and derivatives--and the math and software to analyze and manage them--made the old term imprecise and unsophisticated-sounding. But for a firm with exposure to price risk on real physical barrels, the basic principles never really changed: understand the risk, match the "basis" (the relationship between what is being hedged and the commodity/location for which a futures/options/derivative contract is available) as closely as possible, see where you are at the end of every day, and never lose track of the connection between the value of your physical commodity and your profit/loss on the hedge.

What is not clear from the coverage I've seen is this final, all-important question about the value of the physical oil. If CAO was able to capture all of the upside on its physical jet fuel transactions that it gave away on the derivatives contracts it entered into, then what we have here is an accounting problem and a large opportunity cost. But if, as the articles hint, CAO was essentially buying and selling product at market prices, while taking a speculative bet on the price of jet fuel and rolling their losses forward in hopes of a market dip, then you have the worst possible nightmare for the person with ultimate responsibility for this activity: high-stakes casino gambling masquerading as risk management.

Derivatives make an easy scapegoat for losses like these, but I suspect the traders involved could have run up nearly as much red ink doing the same thing in the futures markets, or perhaps more, since they'd have been limited to the commodities and locations for which liquid futures exchanges exist, thus taking on not only price risk but large basis risk, as well.

Whenever an event like this occurs, it gives a black eye to trading and risk management, but it shouldn't deter anyone from using these extremely useful tools, as long as they have clear policies and controls in place, along with the kind of accounting that makes it difficult to obscure losses that are being rolled forward.

Thursday, December 02, 2004

Iran and the NPT
The other major energy-related news item of the last couple of weeks is the negotiations with Iran over its nuclear fuel reprocessing capability, and the implications for nuclear weapons production. Even ignoring the fiery rhetoric coming out of Iran, the European-sponsored agreement announced this week is pretty clearly just a stopgap. Will the time thus bought be spent usefully, or are we merely postponing further unpleasant revelations?

The current deal can be viewed either as a pragmatic compromise facilitated by an effective "good cop/bad cop" act on the part of the EU and US, or as cynical appeasement by European governments eager for more trade with the mullahs and no appetite for confrontation. Whatever the motivation or the subsequent judgment of history, few experts seem to think this agreement will prevent Iran from joining the nuclear weapons club at a time of its choosing. The real benefit may be one I haven't seen articulated: buying time now is worthwhile, because full-blown sanctions on Iran are unthinkable in a world of $50 oil.

Iran currently exports 2.5 million barrels per day of oil, most of which goes to Europe and Asia. This quantity is greater than the most optimistic assessment of the world's remaining spare production capacity, so cutting it off would create a situation analogous to the 1973 and '79 oil crises. I am certain that the Iranian negotiators understand this completely--inasmuch as their own Islamic Revolution precipitated the 1979 crisis--and are taking full advantage of the bargaining power this gives them.

So is there a way out of this situation that won't result in Iran becoming a nuclear power, and in the process blowing the entire nuclear non-proliferation regime to kingdom come? The Wall Street Journal's suggestion of funding the Iranian opposition seems likelier to cost the latter their credibility and ruin any chances of turfing the mullahs out of power. This is a problem that cries out for some fresh thinking.

Wednesday, December 01, 2004

The Long Future of Oil
It's fashionable to talk about the coming Hydrogen Economy, and though I may often sound like a skeptic, I think that many of the elements of a hydrogen-based energy network could be in place in twenty years or so. However, an article about the petroleum potential of the deep Arctic waters got me musing about the long-term future of oil, which may be much longer than some expect.

If you extrapolate current oil production trends, by 2040 most of the conventional production in the US, Canada, and North Sea will be tapped out, and virtually every current producing country outside the Middle East will be in decline. Even if hydrogen (presumably generated by some non-fossil fuel source, such as renewables or nuclear) were to make major inroads into oil demand by this time, there would still be a need for significant quantities of oil, to supply those parts of the world that couldn't afford to make a transition to hydrogen, and for aviation, petrochemicals and other non-road demand sectors.

Saudi Arabia (assuming it still exists as a country 35 years from now; after all, it is only about twice that old now) should still be a major producer in 2040, as would Iraq and Iran. But would the world want to rely entirely on Middle Eastern oil, and could the Middle East by then cover even a diminished global appetite for oil? Where else might the oil come from?

That's where the potential described in the article on the Arctic comes in. By 2040, a substantial proportion of the world's oil--even if oil were well on its way to becoming obsolete--would have to come from unconventional sources, such as oil sands or heavy oil (see my posting of September 23.) In addition, resources that have yet to be identified, in ultra-deep waters (beyond the continental shelves?) or ultra-remote areas, such as the Arctic and Antarctic, would have to contribute materially to supply. That would raise all sorts of interesting questions about who owns the rights to those resources. Nor can one discount the possibility that in 35 years biotechnology and/or nanotechnology could either unlock the huge amounts of presently unrecoverable oil in abandoned reservoirs, or generate synthetic oil in large quantities.

Note that I haven't said anything about the price required for this to play out, or about the possibility of a truly superior energy technology, such as nuclear fusion. Barring such a development, and depending on the future attitude toward climate change and the long-term decarbonization of energy (which some claim is starting to reverse), oil could still be an important commodity well into the next century, and that implies some pretty exotic oil technology, rivaling anything the Hydrogen Economy has up its sleeve.