Monday, June 28, 2010

The Energy Transition Is Already Underway

Lately I've been struck by the number of new groups and proposals calling for America to begin the transition to cleaner energy. We even heard this call from the Oval Office several weeks ago. Yet while there's clearly much more to be done to wean ourselves from our reliance on oil and other high-carbon fuels, I'm baffled by the suggestion that this process didn't actually begin long ago--not just in the last year and a half--with policies and R&D initiatives put in place by at least the previous two administrations. Perhaps it's fashionable to ignore our progress to date, because acknowledging it serves as a reminder that the process will require decades to complete, and that the end-point might not resemble the one we imagined when we began.

Let's start by recognizing that a massive energy transition is already well under way on many fronts, including the development of advanced biofuels, nearly-mature wind power, highly fuel-efficient vehicles, electric vehicles, solar power that's not just a science fair project, and a range of other technologies and policies for reducing oil consumption and greenhouse gas emissions. These didn't just appear spontaneously; most required literally decades of effort to get to this point. So if we're already headed down this path, rather than arguing about starting out should we rather be asking how much we can do now to accelerate this shift?

Take fuel economy, which seems simple, because we all understand miles per gallon, or think we do. But how many people realize that the incremental fuel savings from higher mpg shrink as mpg increases? The chart below shows the annual fuel consumption for a car driving 12,000 miles per year, about the national average, versus fuel economy in mpg. The improvement in Corporate Average Fuel Economy of new cars between 1978 and 2008, from about 20 mpg to 27 mpg, has already saved a very substantial 160 gal/yr per car, while the increase to 34 mpg by 2016, the new CAFE target, will save another 90 gal/yr. However, advancing from there to 44 mpg, roughly equivalent to the 2012 EU target of 130 grams of CO2 per kilometer, would save only an extra 80 gal/yr. That's no reason not to move ahead with more efficient cars, but we must recognize that we've already captured the steep part of a curve that is now flattening out, as the cost/benefit of each successively-harder increment diminishes, unless they burn no oil at all. That's where biofuels and EVs come in.
The Renewable Fuels Standard established by Congress in 2007 calls for a quantity of advanced and cellulosic biofuels by 2022 that exceeds what we currently get from corn ethanol. The problem is that at this point, after many years of hard work developing these technologies, there is not a single commercial-scale cellulosic biofuel facility design that has been built, tested and certified for profitable replication on the scale required, despite a special production tax credit of $1.01/gal. Nor do I conclude that's for lack of the government, private investors and big companies like ExxonMobil, Chevron, Shell, and BP throwing plenty of R&D dollars at the challenge. Within a few years we might be at the point at which billions of extra dollars for advanced biofuels would result in hundreds of such facilities actually being built, but then plenty of experts thought we would already be at that point by now, including the EPA, which had to ratchet back its cellulosic ethanol quota for this year from a level equal to the annual output of one corn ethanol plant to the quantity that a corn ethanol plant produces every three weeks or so.

The prospect for EVs looks more immediate--though still on a relatively small scale--with GM and Nissan launching flagship models later this year. However, as I noted in a recent webinar, every million EVs running entirely on electricity would save 31,000 barrels per day of gasoline, or about 0.3% of our current usage, and that's assuming they would replace cars getting today's average mpg, rather than Prius-type non-plug-in hybrids, as seems likelier to me. It's going to take a whale of a lot of EVs to make a real difference, and it's not yet obvious that offering more than the current $7,500 in consumer tax credits to buy them, or handing out more than the billions that have already been given to car companies--including some that have never built a mass-produced car--is going to put a lot more of these vehicles on the road in the next few years than would happen under existing policies that are still playing out.

However attractive energy visions such as the President's might be, even to me, there are practical limits to additional activism at a point when so many wheels have already been set in motion. I do understand that the nation is riveted by the oil spill, and that transforming this interest into support for a broader energy agenda could be a once-in-a-generation opportunity. At the same time, I worry about an approach that relies on expanding already-unsustainable financial incentives for clean energy deployment at a time when the deficit has taken on the aspect of a black hole threatening to devour our future, energy and otherwise. To see the energy transition really take off, we must reach the point at which the alternatives are unambiguously better/faster/cheaper than oil, or can at least match its cost and convenience in its primary transportation energy uses, and are not merely better for the environment--as important as that is. We're not there yet, but we've clearly already begun the journey.

Energy Outlook will be on holiday the rest of this week and through the July 4th weekend.

Thursday, June 24, 2010

Where's the Peak?

I've been going through the International Energy Agency's new forecast for medium-term oil and natural gas markets, issued yesterday. In contrast to the IEA's warnings of last summer concerning an imminent oil supply crunch, the agency now sees ample supplies to accommodate the level of demand growth it anticipates for the next five years. Yet while this scenario does not envision a peak in global oil supplies before 2015, its components offer ample cause for concern about the growing market power of OPEC and the risk of geopolitical disruptions. It also signals the growing importance of non-traditional sources of liquid fuels, including natural gas liquids (NGLs) and biofuels, which are included in the IEA's oil supply & demand balance.

The headline features of the IEA's oil forecast include continued growth in global oil capacity from 91 million barrels per day (MBD) in 2009 to 96.5 MBD in 2015. This is driven by the growth of OPEC's capacity, the NGL output of a global natural gas expansion that the US shale gas boom has accelerated, and increased production of ethanol and other biofuels. IEA sees this combination as more than sufficient to counteract a roughly 3.5% annual decline in the output of existing oil fields, including a peak and net decline in non-OPEC production within the next year or two. The latter won't surprise anyone who's been following the Peak Oil issue, but it's all the more worrying when you consider that it doesn't include the impact of project delays owing to the on-again, off-again US deepwater drilling moratorium, which the administration seems determined to switch back on.

This picture is fraught with risks and vulnerabilities, including the prominent role of Iraqi oil revitalization projects, which appear to account for half of the growth in OPEC crude oil capacity in the period. Although there's ample scope to stimulate more output from Iraq's mature fields, and the potential of its undeveloped fields represents the largest conventional oil opportunity in the world, none of it will come to fruition if the county doesn't remain quasi-stable. This might be one area in which the reassignment of General Petraeus to Afghanistan from his CentCom post, where he retained oversight of the Iraq security situation, might not look so positive.

Then there's that shift toward NGLs and biofuels, including the IEA's somewhat surprising prediction that while biofuels will continue to grow globally, the rate of growth will slow, with US output reaching a plateau long before it has attained the targets of the Renewable Fuels Standard. They also appear to be even more skeptical than I am that cellulosic ethanol is on the verge of scaling up rapidly. The larger problem is that both of these sources constitute what I would call "hamburger helper" for oil. Neither ethanol nor first-generation biodiesel (FAME) constitutes an effective gallon-for-gallon substitute for petroleum products, except in blends limited by both infrastructure and legacy vehicle fleets not equipped to handle more than small percentages of these fuels. NGLs provide propane and butane essentially indistinguishable from crude-sourced LPG and just as useful for petrochemicals and heating fuel, but they yield much less in the way of gasoline components, and the ones they do require significant processing to boost their octane, now that tetra-ethyl lead is out of the picture.

On the demand side, things look pretty much as we'd expect in the aftermath of a global recession that hit the developed world harder than the big developing countries--BICs, if not BRICs. As was true before the financial crisis, however, the Middle East contributes the second-biggest source of new demand, after Asia. That means continued growth in domestic demand within some of today's largest oil exporters. Even if that doesn't lead to "peak exports", it buttresses the fundamental shift in global market power underpinning a forecast that might otherwise appear calming to markets.

Anyone looking to the IEA for signs of an imminent peak in global oil supplies won't find it in their Medium Term Oil and Gas Markets 2010 report. What I see instead is a continuation of the world we are already in, with OPEC holding the trump cards. Traders tend to focus on the weekly fluctuations of oil market inventories and indications that supply or demand may grow or shrink in the months and years ahead. Yet while the release of this report, together with another build in US crude inventories this week, reportedly contributed to the $2/bbl drop in oil prices in the last two days, these reactions seem oblivious to a larger reality. With more than 5 million barrels per day of OPEC production capacity shut in, the main reason that oil is trading in the mid-to-high $70s, rather than the mid-to-high $40s, is that OPEC is functioning as a truly effective cartel that is much happier with higher prices. Politicians looking for another economic stimulus might consider the anti-stimulus that oil prices are currently providing, and the consequences of policies that could hand even more power to OPEC in the short-to-midterm.

Tuesday, June 22, 2010

Revulsion vs. Hard Choices

I don't know anyone who could gaze at the images of oil-slimed pelicans, gulls, and sea turtles and not feel revulsion and regret. Yet beyond the urgent need to plug the gushing well, protect the coastline and fisheries, and restore the Gulf Coast environment as rapidly as possible, we cannot allow our entirely appropriate emotional response to this tragedy to overwhelm our judgment. As bad as this spill is, our long-term challenges of energy security and climate change remain worse. We would only compound the damage if we allowed our reaction to this spill and its ripples beyond oil to further confuse our energy policies.

In his column in yesterday's Washington Post, Robert Samuelson sharply criticized the President's effort to harness the public's frustration and outrage against the spill into support for his energy and climate change agenda. Mr. Samuelson raised some very salient points concerning the difficulties of attempting to reduce our consumption of fossil fuels at the same time we must meet the expanding energy needs of a growing economy and population. However, I think he missed the deeper contradiction that has been created by the "strange bedfellows" coalitions that have formed since the middle of the last decade, marrying concerns about climate change to the urgent necessity of improving our energy security. As long as the shared enemy was foreign oil--from "countries that don't like us"--these groups could emphasize the overlaps in their positions and mostly ignore the resulting inconsistencies. But with the reaction to the spill turning the political tide against domestic oil as well as the imported kind--and perhaps, by extension, against natural gas derived from the hydraulic fracturing of shale reservoirs--the convenient overlap between climate policy and energy security could vanish.

If that sounds counter-intuitive, perhaps it's because so much of what we've been told by our leaders concerning our energy options has ignored the fundamental mismatch of scale between fossil fuels and our rapidly-growing renewable energy sources. Consider that while US ethanol production has grown by an astonishing 660% since 2000--an average of 23% per year--it still equates to just 2.4% of our annual oil consumption. Non-hydropower renewables, including wind power, which has grown by an even more remarkable 34% per year since 2000, made up just 3.6% of US electricity supply last year. These facts are crucial to the debate, not because these energy sources should be regarded as inconsequential, but because at their current and anticipated near-future output renewables provide a form of energy currency that can only be spent once. If we want to expand wind, solar, geothermal and biomass power to reduce the greenhouse gas emissions from coal-fired power generation, we cannot spend them again on powering electric vehicles to displace petroleum-based transportation fuels. If we want to leverage biofuels to back out imported oil, we can't spend the same biofuels to take the place of oil we won't be getting from offshore wells we aren't drilling. Someday, biofuels and renewable electricity sources may have grown enough to take on all comers, but that day remains over the horizon. And while nuclear power is already contributing on a much larger scale, its expansion will take many years, particularly if we begin retiring older nuclear power plants like Vermont Yankee in the interim.

Natural gas operates in a similar realm of hard choices, though on a larger scale. It currently accounts for nearly one-fourth of our total energy consumption. Last year, with electricity demand down and gas prices at less than half their level of just a few years ago, natural gas-fired power generation made significant inroads into the market share of coal-fired power. That was good for consumers and good for the environment, but it was only possible as a result of the dramatic resurgence of US gas production from the development of shale gas supplies. Together with coal bed methane and gas from tight sands, these unconventional sources now make up half our domestic natural gas output. Yet as with renewables, if we want to use this additional gas to reduce the 40% of US CO2 emissions coming from the power sector, we can't employ the same gas to displace gasoline in cars or diesel in trucks. And without the contribution of shale gas made possible by "fracking", gas would likely be too expensive to substitute for either oil or coal.

We have a wealth of new and old options for addressing both our greenhouse gas emissions and our reliance on imported oil. However, at this point that bounty of choices does not extend to backing out all oil while still reducing emissions. With biofuels and renewable electricity already fully committed to our established energy priorities, our only large-scale option for foregoing the enormous energy resources embodied in the deepwater oil reservoirs of the Gulf Coast--other than simply ramping up oil imports--would require converting coal into liquid fuels. We have off-the-shelf technology to do this, but unfortunately not yet to contain the large increase in CO2 emissions that would accompany such a strategy. Perhaps before we commit ourselves to anything beyond the shortest suspension of deepwater drilling necessary to ensure that it can proceed safely, we should clarify what our national energy priorities really are. A change in the implicit direction in which we've been heading could have far-reaching and enormously expensive consequences, including for the environment.

Thursday, June 17, 2010

Expand the Presidential Commission on Deepwater Horizon

Amid the other news this week, including the President's address to the nation on the Gulf Coast oil disaster and his meeting with BP officials yesterday, the announcement on Monday of the five remaining members of the Presidential Commission to assess the "environmental and safety ensure an accident like this never happens again" seems to have sunk without a trace. I don't recall seeing it mentioned in either the Washington Post or Wall St. Journal. I ran across it in the New Orleans Times-Picayune online last night. Yet it's clear that the staffing of such a commission has an enormous influence on its approach and ultimate findings, and on both counts I am seriously concerned. From my review of their published bios, I cannot discern that any named member possesses any direct training or experience with the technology and practices of offshore drilling, a field that in its own way is every bit as complex as aviation, terrorism, or other past subjects of similar commissions.

The gold standard for Presidential commissions investigating accidents of national importance was set by the Rogers Commission on the explosion of the Space Shuttle Challenger shortly after its launch on January 28, 1986. The commission--not just its technical staff--was packed to the rafters with figures of national prominence and deep expertise in aviation and space technology and operations. Headed by former Secretary of State William P. Rogers, it included Neil Armstrong, the first astronaut on the moon, Dr. Sally Ride, first American woman in space, Gen. Chuck Yeager, first pilot to fly faster than the speed of sound, Gen. Donald Kutyna, an expert on spacecraft launches and accidents, and Joseph Sutter, the "father" of the Boeing 747, along with an aeronautical engineering professor, an aircraft designer, a solar physicist, and several other leading experts on aerospace matters. Last but never least was Richard P. Feynman, Nobel Prize-winning physicist, quintessential iconoclast, and perhaps the smartest and most inquisitive human being ever to walk the earth, with the possible exception of Albert Einstein. It was, of course, Dr. Feynman whose famous ice-water experiment with the solid rocket boosters' O-ring material uncovered the root cause of the disaster.

Each of the fine individuals President Obama has named to the Deepwater Horizon Commission brings valuable experience and an important perspective, including that of a professional environmentalist, biological oceanographer, an accomplished physicist and manager of science, and a pair of lawyers with past experience in various aspects of the Exxon Valdez spill and cleanup. I have no objection to any of them individually. However, collectively they are not a patch on the Rogers Commission.

The obvious solution to this problem is that the President should immediately expand the commission to include at least two additional members, and preferably four, with deep expertise and experience in oil & gas drilling, geoscience, and offshore industry operations. It is absolutely essential that the commission includes people who understand not just the ocean environment, but also subsea geology, drilling technology, and relevant oil & gas industry practices, first-hand. They should of course have no connections to BP or to any other company that stands to lose or gain from the commission's findings. While that might narrow the field somewhat, it would not rule out the faculties of the leading petroleum engineering and geosciences university departments, or a wide swath of recently-retired experts in these fields. The US is blessed with abundant expertise in this area, and it would be a crime to exclude it from this vital study.

Despite a nearly universal desire to accelerate our shift away from petroleum in the wake of this disaster, we are nowhere near being able to turn our backs on either the energy or convenience we get from oil. As I've shown in a series of postings since the accident occurred, offshore drilling is a crucial component of US domestic energy supplies, and no current alternative energy source operates at either the scale necessary to replace it, or in sufficiently direct substitution for the transportation energy of which oil is our principal provider. The less oil we produce domestically, the more we will have to import.

In this context it is of the highest importance that the commission be given the best chance possible to interpret the findings of the technical investigations of what went wrong on the Deepwater Horizon rig, and to determine how to structure an approach to offshore drilling that reduces the risks posed by human error and technical failures to the maximum degree possible. Every member of the commission has important contributions to make in this regard, but without the match between relevant experience and the nature of the problem exemplified by the Rogers Commission, the Deepwater Horizon Commission will be operating at least partly in the dark.

I don't often urge my readers to take action on the subject of one of my blogs, but in this case, if you share my concerns about the omission of critical experience from the staffing of this commission, you should contact the White House and your Representatives in Congress to express that view.

Tuesday, June 15, 2010

Walruses and Wake-Up Calls

I just finished watching today's hearing on offshore drilling operations and safety by the Energy and Environment Subcommittee of the House Energy & Commerce Committee, featuring the CEOs of ExxonMobil, Chevron, and ConocoPhillips and the US heads of Shell and BP. Rather than giving in to the temptation to deliver a rant on the current level of dysfunction in Congress, I want to highlight a few things that stood out for me in the testimony of the assembled chiefs of the largest oil companies in the US, and then focus on the central dilemma that was explored in the hearing.
  1. Although couched in careful language referring to the importance of completing the full investigation of the circumstances involved, the heads of the other companies came as close as anyone could reasonably expect to saying that BP's well design for Macondo and the processes for drilling it would not have passed muster in their companies.
  2. A series of very interesting questions focused on the prevalence and effectiveness of "stop-work" policies, in which any employee or contractor on a rig can call a halt to drilling if he or she sees something that looks dangerous. BP indicated it had such a policy in place on Deepwater Horizon. However, John Watson, the CEO of Chevron (in which I own stock) pointed out that in order for such policies to be credible, employees who exercise that initiative must be recognized and rewarded. After all that we've learned about the warning signs on this well, I suspect I'm not alone in having difficulty imagining a "stop-work" call having been welcomed in this case. Corporate culture matters.
  3. In one sentence, ExxonMobil CEO Rex Tillerson calmly demolished the half-baked notion that every deepwater well be required to have a relief well drilled in parallel, just in case it would be needed. (This was done in such a low-key way that the questioner didn't seem to grasp what had been said.) Instead of mentioning the doubling of cost involved, Tillerson pointed out that this strategy would double the risk of every project. The risks of a parallel relief well would be the same as for the exploration well, because it would be another exploration well.
  4. Sometime later Congressman Scalise from Louisiana picked up on this theme with a question that should have galvanized the room, but somehow didn't. He asked BP North America President Lamar McKay if the relief wells at Macondo were being drilled to the same plans as the blown-out exploration well. Answer: yes, with oversight at every step of the way.

I'm sure I'm neglecting other important comments, though I'm also dismissing the first hour-and-a-half of the hearing, which was frittered away in a blather of posturing and wild "gotcha" chases involving extinct Gulf Coast walruses and dead experts' telephone numbers. But despite all of this, I thought the crux of the problem concerning how to address the other Gulf Coast deepwater leases came through in some astute questions and surprisingly candid answers. Many of the members recognized the importance of the resources involved to the economy of the region and to the energy and national security of the country, and the serious damage that the drilling freezes are inflicting. At the same time, they highlighted the breakdown of the public's trust in the industry to extract these resources safely, despite the statistical evidence that, with 14,000 deepwater wells drilled globally, the Macondo well stands as an anomaly at a single company. The industry representatives also made it very clear that the primary defense against the effects of uncontrolled blow-outs such as this one lies in prevention, rather than clean-up, for which the industry was not adequately prepared to handle a spill on this scale. That's a situation that can't be rectified within six months, and possibly not six years, though the innovations and inspiration coming out of this disaster ought to provide a substantial kick-start to bringing spill-response into the 21st century.

That leaves our government with a monumental dilemma regarding the resumption of offshore drilling. One answer is the total risk avoidance of the current freeze, which appears politically motivated, but for which its supporters might point to some of today's testimony. Unfortunately, the freeze will inevitably increase our reliance on imported oil, because as much as we recognize the need to move in the direction of renewable energy and other alternatives, there is currently no other meaningful substitute for the oil that we now get from deepwater, unless we are willing to consider the risk tradeoffs involved in targeting new domestic oil production on onshore and shallow-water resources that are presently off-limits, such as those in the Arctic National Wildlife Refuge. Another, admittedly riskier solution would be to allow companies other than BP, using designs and procedures in conformance with the industry guidelines developed by the American Petroleum Institute and broadly similar to those just recommended by the Department of Interior, to resume drilling on projects already under way, while the investigations and Presidential commission determine the longer-term measures appropriate for new leases. I lean strongly toward a selective resumption, but the responsibility involved is literally awesome and properly resides with our elected leaders.

Monday, June 14, 2010

Europe's Oil Price Spike

In our relentless focus on the excesses of the financial sector, many Americans have forgotten that the severe recession we've just experienced was at least exacerbated, if not partially caused by an oil price shock. Now it might be Europe's turn, as the Euro continues its slide against the US dollar. It's a fairly obvious point that a weakening Euro increases the cost of all commodity imports into the EU's Eurozone, while reducing the effective revenue for any exports made with them. Yet when the import is oil, the effects go beyond international competitiveness.

Oil prices have roughly doubled in dollar terms since their low point in January 2009, but they have gone up by an extra 25% in Euros per barrel over the same interval. The divergence this year is even more striking, as the Euro retreats from its highs of last December. Since January 1, oil is up by nearly 6% in €/bbl but down by nearly 12% in $/bbl, as shown in the chart blow. A further retreat to Euro-dollar parity would see the Eurozone's businesses paying nearly as much for oil in their own currency as they did in September 2008, the last time the US saw prices over $100 per barrel.

The previous strength of the Euro partially insulated the Continent's businesses and consumers from the worst oil-price pain of the first half of 2008. When oil reached its all-time high of $145/bbl in July of that year, it was barely over €90/bbl. Then, as oil prices ebbed, the strong currency/weak oil combo provided a substantial economic stimulus to Europe lasting well into 2009, with oil averaging just €44/bbl last year, compared to $62 here.

The shoe is on the other foot, for now, as Europe enjoys little of the recent weakening of oil prices from levels above $80/bbl, while experiencing a mini-spike since the start of the year. And with various pundits suggesting the Euro still has a ways to fall, Europe could be facing oil prices over €70/bbl, instead of the roughly €60/bbl for which UK Brent Crude effectively trades today. That would compound the fallout from the EU's fiscal crisis and amplify the risk of a double-dip recession, perhaps even globally.

Friday, June 11, 2010

Emissions Twilight Zone

The defeat yesterday of a Senate resolution to rein in the application of the Clean Air Act to greenhouse gas emissions, together with the recent announcement by Senator Lindsey Graham that he would vote against the climate bill he helped Senators Kerry and Lieberman to draft, puts US efforts to deal with climate change into a sort of Twilight Zone, in which the widely-preferred approach of most of those wishing to tackle our emissions directly sits on the sidelines, while EPA regulations that were allegedly intended mainly to scare Congress into passing a climate bill this term now look nearly certain to take effect next year. No one on any side of the issue should rejoice at this outcome.

I confess that I haven't found the time to give the Kerry-Lieberman draft climate bill the same degree of scrutiny that I applied to the Waxman-Markey bill that the House of Representatives passed last summer. Based on the summary that I have read, K-L appears to address at least some of the serious flaws in Waxman-Markey, though the devil is often in the details of provisions such as restrictions on who would be allowed to trade emissions permits. In general, I'm pleased that more of the revenue from emissions permits would flow back to consumers and taxpayers under this bill than in the House version, and less would be diverted to favored constituencies or outright pork. That should reduce the net burden of emissions restrictions on the economy as a whole, a crucial concern when the recovery is still fragile. However, the inclusion of offshore drilling provisions that look to some like an endorsement of a practice that has become hugely controversial since the Gulf spill, but that from my reading could shut down most offshore drilling permanently--a conclusion Senator Graham now seems to share--has probably derailed the bill's chances for passage this year.

So without a legislated cap on emissions and a market-based mechanism to distribute the cuts to those parties with the greatest capacity to achieve them at the lowest cost--the essence of the "trade" portion of cap & trade--the EPA will now determine where and how emissions should be cut. That is the least-efficient way to go about this that I can imagine. It's even a mixed blessing that the EPA's "Tailoring Rule" would initially focus application of the Clean Air Act on new or expanding facilities adding large quantities of GHG emissions--one dimension of economic growth--rather than on all existing facilities, though the latter seems to be on tap for Step 3, due in 2013. As described, Step 3 would apply to any facility emitting more than 50,000 tons per year of CO2 equivalent GHGs. That's a lot more than your local pizza shop or most small businesses, but it's not quite as small as it's been portrayed. 50,000 tons is roughly the CO2 emissions from a business or facility consuming a mix of energy equal to two tanker trucks of gasoline or diesel fuel per day, or 9 Megawatts of average US grid electricity around the clock.

One of the ironies of the situation is that anyone now opposing legislation putting a price on carbon because they're not convinced of the risks of climate change is effectively supporting the EPA's approach to emissions. Perhaps that just means that they see the current Congress as a high-water mark of support for aggressive action on climate change and suppose that a future Congress--say, after November's mid-term elections--would be more willing to take the EPA out of the climate change business. Nevertheless, at least for now, the alternative to legislation like the Kerry-Graham bill is not inaction, but command-and-control regulations that could be much more damaging to a weak economy.

Wednesday, June 09, 2010

Iran and Oil Price Risk

Today's UN Security Council vote on a further round of sanctions on Iran merits attention. While the U.S. and its key allies were able to get a somewhat diluted slate of new sanctions passed, the vote may be as notable for the "nays" cast by Brazil and Turkey as for the "ayes" it received from Russia and China, along with Lebanon's abstention. It looks like Iran has astutely leveraged the fraying of traditional alignments following the global economic shake-up of the last two years. The significant recent deterioration of Israel's image and standing probably played a backstage role, as well. It's a toss-up whether this new configuration makes an eventual confrontation over Iran's nuclear program more or less inevitable than previously.

Tensions over Iran's nuclear program have been moderated somewhat by ongoing diplomatic initiatives that have fragmented into parallel conversations between Iran and the US plus its closest European allies, Iran and its neighbors, and Iran and various emerging and non-aligned countries. However, jaw-jaw aside, Iran is either moving inexorably towards a nuclear weapons and delivery capability or putting on a pretty convincing Potemkin show of this for its own inscrutable reasons, reminiscent of Saddam Hussein's WMD sham of a few years ago. Either way, this still looks like the biggest unresolved political risk hanging over global oil markets, even if they're presently too distracted by the turmoil in currency and stock markets and the wave of offshore oil exploration bans emanating from the Gulf Coast leak to pay much attention to the risk of conflict.

This dance has been going on for years, but important elements have changed recently in ways that might alter calculations of the risks of a military strike by Israel--or anyone else--on Iran's facilities, relative to the risks of allowing Iran to produce a warhead and match it to its increasingly sophisticated missile technology. Last week's fiasco involving Israel's interdiction of a convoy of ships carrying aid to Gaza looms large, for several reasons. First, it has further isolated Israel from traditionally sympathetic countries in Europe and elsewhere. That could be crucial in the aftermath of any Israeli moves against Iran. In addition, Israel's action alienated low-key regional ally Turkey, not least because the convoy sailed from Istanbul and most of the fatalities were Turks. When Iran, Turkey and Russia meet to discuss regional security, it's a pretty clear sign that things are changing in noteworthy ways. (The slow drift of Turkey out of the western orbit after years of being rebuffed for EU membership may go down as one of the biggest missed opportunities of the post-Cold War era.)

As another Washington Post article indicated this morning, the latest sanctions might bite a little harder but could leave Iran's leaders feeling they have come out ahead in this round. If so, they won't be deterred to any greater extent from pursuing their oft-denied but widely-assumed nuclear aims. Meanwhile Israel has even less scope than before to launch an Osirak-style attack without facing a crippling response from its friends. As I noted last fall, the window of opportunity for resolving this slow-burn crisis without risking intolerable consequences for oil prices will not remain open indefinitely.

Tuesday, June 08, 2010

Winners and Losers from the Gulf Spill

A comment on my recent posting on oil substitution opportunities in the aftermath of the Gulf oil spill got me thinking about potential winners and losers from the broad changes that seem likely to ensue from this disaster. Some of these outcomes would depend on new laws and regulations that could alter the basis of competition within the oil and gas industry, between it and other energy sectors, and between specific energy technologies. However, I also wouldn't discount the possibility of enduring changes in our perceptions of the oil industry and of the ways in which we use oil.

Until President Obama acted to freeze new deepwater leases and drilling permits, and even drilling that was already permitted and underway--a freeze that MMS appears to have used its own initiative to extend to all offshore drilling at any depth--natural gas seemed an obvious winner from any constraints on offshore oil drilling. Now I'm less sure, even if the President is apparently ready to allow drilling in shallow waters to resume. Superficially, gas should come out ahead, because the Gulf of Mexico accounts for a smaller fraction of US natural gas production than oil production, at 11% vs. about 30%. Yet it's also my understanding that offshore gas fields tend to decline more quickly than offshore oil fields, so that gas production in the Gulf of Mexico could drop faster than oil output under a deepwater drilling ban.

More importantly, shortfalls in Gulf Coast gas production could have a bigger impact on US natural gas prices than reduced Gulf Coast oil production would on crude prices. That's because the gas market is still mainly regional, connected by relatively small and expensive global flows of LNG, while oil is a truly global commodity with significant flexibility to work around localized production problems. Although the comparison is only approximate, you can see this effect by examining the impact of Hurricanes Katrina and Rita on the prices for Henry Hub natural gas and West Texas crude oil. Between August 25 and October 5, 2005, the gas futures price spiked by 45%, while WTI actually dropped by 7%, because of the extent of refinery shutdowns caused by the storms. (Gasoline futures shot up by 33% but quickly fell back to where they had been.) In other words, ensuring that gas remains cheap enough to be an attractive substitute for oil in transportation and other uses depends on either restoring gas drilling in the Gulf at all depths pretty quickly, or expanding onshore shale gas production even faster than recently.

The situation for renewables looks much less ambiguous. Even though, as I have pointed out frequently, renewable electricity sources such as wind, solar and geothermal power don't substitute for oil in any meaningful way, at least not without millions of electric vehicles that will take many years to roll out, perception is a good bet to trump hard-nosed realism in this situation. Extending the stimulus benefits for renewables, especially the cash grant program that substitutes for the tax equity market that stalled during the financial crisis, looks a lot likelier today than prior to April 20, despite the massive federal budget deficit. Similarly, the ethanol industry stands a better chance of getting the administration to relax the 10% blending limit on ethanol in gasoline--a limit that would otherwise stall ethanol growth until E85 takes off, if ever. The EPA is expected to rule on this soon.

Nuclear power looks like another big beneficiary of the oil spill, and again not because nuclear power would substitute for much oil in the near-term, though nuclear blogger Rod Adams properly reminded me recently that electricity from nuclear plants could be just as effective at backing out heating oil as natural gas, via efficient geothermal heat pump systems. Electrification could also displace some oil in rail transport, depending on the cost-effectiveness of electrifying long-distance freight tracks and locomotives. But in any case, nuclear stands as the likely surviving "conventional energy" pole of any grand compromise on energy and climate legislation, now that offshore drilling has become a dead weight instead of a vote-attractor in the Kerry-Lieberman climate bill. It is also the only other low-carbon energy source currently available on a scale large enough to substitute for the energy we get from oil, though not for oil's attributes as an energy carrier and storage medium.

Assessing whether the US oil & gas industry wins or loses from all this is harder than it looks. Other than BP--an obvious loser--some companies stand to gain from improved economics and increased emphasis on onshore drilling in places like the Bakken formation, from better onshore gas and LNG economics, or from picking up opportunities that BP won't be offered. Even if they're not barred from bidding on new leases around the world, BP just won't look like anyone's partner of choice, at least for a while. And don't forget OPEC, which from the first day of this disaster looked like the single biggest winner from our misfortune. Anything that makes non-OPEC oil production more difficult or costly shifts more market power to OPEC, which is sitting on top of more than three-fourths of the world's proved oil reserves, much of it still fairly cheap to develop.

With one very large caveat the US public, as both consumers and taxpayers, looks like the big loser from the likely energy outcomes of this spill--as distinct from those whose livelihoods and environment have been affected directly. We'll all pay more for energy, at least in the medium term, and we'll pay more to subsidize alternatives that still need help to become competitive, as well as those that should already have been weaned off subsidies after decades at the trough. We might turn that prospect on its head, however, if the spill drastically changed our attitude towards energy consumption. Until this event, oil was largely invisible. Every day in the US a thousand times as much oil as has been leaking into the Gulf flows through pipelines, tankers, barges, rail cars and tank trucks, and eventually through hoses into the fuel tanks of our cars, trucks, trains and planes, all unobtrusively out of sight. This undersea gusher provides a rare visual hint of the sheer scale of our oil consumption. Could seeing all that oil lead Americans to think differently about how they use energy, and from which sources? Let's check back a year after the well is plugged and the story has moved off the front pages.

Thursday, June 03, 2010

The Fate of BP

Yesterday I participated in an online panel (registration required) exploring the implications of the Gulf Coast oil spill. As the panelists were waiting for the webinar to begin, the moderator suggested a few questions he thought might come up. Although we never got to the one on the future of BP, a quick read of today's news suggests this remains a highly relevant question for the public and for BP's investors, retailers, and suppliers. While I'm not ready to hop on the bandwagon in thinking the company might end up being taken over by a competitor, I don't think we can rule out that possibility. In any case, it seems almost certain to end up a very different company than it was prior to April 20, 2010. That could have implications not just for the oil & gas industry, but also for the renewable energy sector, in which BP has been an active participant.

The first article that caught my eye this morning pondered whether Mr. Hayward was likely to survive as the company's CEO. Anyone presiding over a 34% decline in market value within the space of a few weeks--and not as part of an overall market crash--ought to be concerned about his tenure. Still, I would be as surprised as several of the experts the Wall St. Journal interviewed if the company's board saw fit to fire him before the well was secured and the investigations completed, barring credible evidence of serious errors of judgment on his part. In any case, I find the speculation about a takeover of the company much more interesting.

Even in its weakened state, BP is still a mighty big fish for someone else to swallow. As of this morning's trading, its market capitalization stood at $119 billion. As an article in today's Financial Times highlighted, that rules out all but a small handful of possible acquirers. For me the potential of an acquisition hinges less on the relative size of BP and the various firms that might be able to absorb it, than on the underlying "industrial logic." The fact that the firm is about $68 B cheaper than it was in mid-April doesn't make it a bargain, because it has acquired a large new set of liabilities, the value of which can't be accurately assessed, yet. That's true even short of a finding of criminal negligence, which various politicians have hinted at, but that remains entirely speculative at this point. I believe the real issue is whether after all damages and claims are paid the lasting harm to BP's brand and reputation is so severe--and so tangible--that its assets and operations would clearly be worth more within another large energy company.

First consider BP's capacity to cover the costs of the spill cleanup and pay all the claims accumulating against it. The media and politicians have focused mainly on the company's first quarter 2010 profits of either $5.5 B or $6 B, depending on how you measure them, though I believe that its annual cash flow and the disposition of that cash flow provide a clearer picture of its ability to pay for damages. A quick look at the financials in its 2009 Annual Report shows that from 2007-2009, BP's annual cash flow from operations averaged $30 B per year. This was spent roughly two-thirds on its capital projects budget and one-third on paying dividends to shareholders. At the end of 2009 the company held just over $8 B in cash and cash equivalents. I also scanned the report for any indication that BP had external insurance coverage for such events. I couldn't find any, and media reports indicate they were self-insured. However, even without insurance, BP could potentially pay out many tens of billions of dollars of cleanup costs, damages and penalties, if any, over a period of 3-5 years.

That's not to say that all of that cash flow would be available for such purposes--some maintenance investments would be required in any case--or that this could be done without a significant impact on both the market valuation of the company or its underlying long-term enterprise value. In effect, this is probably a big part of what the market is discounting into the stock price: a sort of rough consensus estimate of the expected value of the impact on the company of the likely payouts. This includes things as simple as the reduced value to investors of a stock paying a lower dividend (or none, as several lawmakers have suggested) to the consequences of constraining its reinvestment in hydrocarbon production that depletes a little bit every day. Other concerns weighing on the value include the perceived effect of any consumer boycotts--there's apparently one gathering strength on Facebook and in multiple YouTube videos--or the loss of government contracts as a result of the possible findings of the various investigations. That could run the gamut from losing contracts to supply the US military with fuel to losing leases to develop new resources. These are also some of the elements that any potential acquirer would assess, to gauge how much of the discount on BP is attributable to factors that could be quickly reversed under other management and an untainted brand.

Based on my experience working at Texaco, Inc. following the Pennzoil verdict, which led to the company's bankruptcy and the payment of a multi-billion dollar settlement, even if BP weren't subject to an acquisition in the short term, its future trajectory might still be so altered by this event and its costs that it would eventually end up much smaller, or perhaps as the subject of an acquisition much later. I see several relevant analogies to Texaco/Pennzoil. First, this matter will continue to occupy the attention of management long after the well is finally plugged. Claims and lawsuits will drag on for months and probably years, and top executives will be testifying before a series of investigations, tort actions, and perhaps even criminal trials. Day-to-day operations probably wouldn't suffer, but it would be very difficult to keep the firm's strategy sharply focused under such conditions. I'd also be surprised if BP didn't miss out on critical opportunities along the way.

Then there's the question of how to pay for claims and damages. At some level, if they exceeded cash on hand and easy borrowing capacity, it would likely make more sense to management to sell assets--or transfer them directly to plaintiffs--rather than funding payouts at the expense of the investments on which the future of the company would depend. The firm will also be under considerable pressure from investors to continue paying out strong dividends, or to resume them if they are suspended at some point in the process. But regardless of how BP chooses to cover its spill-related liabilities, its future capital budgets seem likely to be constrained, and projects with longer payouts or less attractive returns would fall below a higher cutoff line. Given the relative returns of renewable energy projects compared to oil & gas projects, BP's renewables could be an early casualty, unless they are deemed crucial to rebuilding the company's reputation.

While an acquisition will remain possible as long as BP's stock is this depressed, it seems likelier that the company will survive and eventually rebound, though perhaps not to former levels. But even if none of its competitors is willing to take on the big risks an acquisition would entail, let alone navigating anti-trust regimes that are likely to be much less flexible in the wake of the financial crisis, this possibility will have BP's management looking over their other shoulder--the one that the US government isn't already camped out on, adjacent to the "boot on the neck"--until this entire episode is behind them.

I'd like to close with a reminder that a consumer boycott of BP stands a much bigger chance of harming one of your neighbors than it does of hurting BP. Most of the service stations in the US aren't owned and operated by the company whose brand you see on the polesign; they are mainly independent businesses that have a supply contract either directly with the company, or with a regional distributor who has such a relationship. So if you boycott your local BP station, chances are you are not affecting BP, which will resell the product on the wholesale market, but a local business owner who is struggling in a very tough business with slim margins. And in the case of BP, many of these retailers didn't even choose BP. Depending on how long the site has been in their families, many would have originally signed up with Amoco, ARCO, or even Sohio (Standard Oil of Ohio, which BP acquired in two stages in 1978 and 1987.)

Tuesday, June 01, 2010

Setting Energy Goals

With the failure over the weekend of BP's "top kill" effort, the odds that the oil will continue flowing until relief wells can be completed--in months, rather than days--have gone up considerably. In addition to the accumulating economic and environmental consequences, that also means that media attention on the oil spill and the questions it raises about US energy policy will remain front and center for at least that long. In the absence of any formal effort to guide the discussion, we're likely to end up with the usual array of random energy musings and rants, built around an understandable, if unrealistic message of ending our reliance on oil now. That would be a shame, because this sad situation gives us a unique opportunity to refine our thinking about our energy future when much of the country is focused on it.

One comment that I've heard frequently in the last few weeks is that this spill serves as a reminder that oil companies are drilling in depths of a mile or more of water, far offshore, because the easy oil is mostly gone. There's more than a grain of truth in that view, though the full picture turns out to be rather more complicated. While it's certainly true that the mature oil regions of the US have been drilled like a pincushion for 150 years, and that many of the large, important undeveloped oil resources we know about are on the Outer Continental Shelf, there's still a lot of oil in other places, both onshore and in the nearer offshore, in shallower water, that we've chosen not to exploit. Access has driven development at least as much as geology in the last decade or two. In the US, we've made an implicit decision to focus oil and gas development on the Gulf Coast, not because it had the most resources--though it has plenty--or because it was less-densely populated , but presumably because it had already been developed so extensively. In effect, this approach sacrificed the Gulf Coast--whether that sacrifice was ever envisioned in quite the terms we're seeing today--to give us the oil we needed while preserving the beaches and viewscapes of our other coasts.

There's also an international dimension to this issue of access. At the same time the US offshore oil industry has been constrained in a box with only one open end pointed toward ever deeper water, the publicly-traded international oil companies have been progressively squeezed out of world-class oil opportunities elsewhere, as a result of full or partial nationalization and through competition with national oil companies that are guided not by market forces, but by geopolitical ones. As a result of these parallel trends, the major oil companies have focused their efforts where they retained both access and some key advantages over many of their state-owned competitors, usually in the form of technology or management of complex projects. In other words, they've been pushed to the frontiers, such as the deepwater Gulf of Mexico.

While many lament the powerlessness of the US government to plug the leaking well, and some like Admiral Allen ponder whether the government should acquire that capability for itself--a topic for a future posting--we shouldn't ignore that even without banning deepwater drilling the federal government has the power to shift the industry toward less-risky opportunities by expanding its access to onshore and near-offshore resources that are more attractive and less difficult, but have been restricted for years.

Another common response to the spill relates to the incentives for moving away from oil. If we just had more incentives for biofuels and for electric vehicles, goes this thinking, we could quickly wean ourselves off oil and not only do away with the need to import it, but also to drill for it in such challenging locations close to home. While many of my recent postings have been aimed at showing why this can't happen quickly, I want to disassociate myself from what Tom Friedman calls the "petro-determinist" approach. I'm not here to tell you that breaking our addiction to oil is impossible; if I thought that I wouldn't have spent much of my career working on or promoting alternatives to oil. At the same time, with the current euphoria for cleantech and green jobs, someone needs to remind us that if breaking our oil addiction requires a 12-step program, we are only on about step 2. More importantly, it matters how we get there: Not all paths are equally valuable, and we don't have good enough information to determine which ones will work best in replacing a hydrocarbon-based energy system that evolved over the better part of a century.

Consider vehicle electrification, which depends on batteries. If the goal is putting the largest number of mainly-electric vehicles on the road in the shortest time, then we might be on the right track, handing out extremely generous tax credits for consumers to buy fully- or partially-electric vehicles, along with billions of dollars in manufacturing tax credits, grants, loans and loan guarantees for the factories to build those cars and the batteries they require, in addition to installing the recharging infrastructure they'll need. But if our goal is to reduce oil consumption and the emissions that accompany it, then this approach could be counterproductive, particularly if growing concerns about the availability and sourcing of the crucial raw materials necessary to build today's state-of-the-art electric vehicle batteries are correct. Simply put, the batteries in a Prius-style hybrid that never plugs in save many more annual gallons of oil per kWh of onboard storage than the batteries in a plug-in hybrid (PHEV) or full EV. That's true for two reasons that are a function of physics, rather than economics: a) fuel economy is subject to diminishing returns, in which moving from 25 mpg to 50 mpg saves twice as much total fuel as going from 50 mpg to 100 mpg and b) PHEVs and EVs require a lot more battery capacity per car than conventional hybrids.

What both of these examples share in common is that focusing on specific paths instead of outcomes can be counterproductive and multiply risk, instead of reducing it. An oil policy that started with the recognition that we must produce significant quantities of oil domestically during a lengthy transition to alternative and renewable energy sources, and that asked where the best-placed resources were to provide that supply with the least risk, might arrive at a different answer than one that resulted from a series of isolated decisions to place a growing sequence of oil resources off-limits. Likewise, a fuel economy and emissions-reduction strategy centered on annual fuel savings, rather than rewarding consumers and carmakers for concentrating the largest number of batteries into each vehicle, would better leverage vehicle-electrification technology to reduce our reliance on oil. That's particularly relevant when batteries look like a short-to-medium term constraint and their raw materials might impose longer-term limits until we have better battery technology based on cheap and plentiful raw materials.

If the Gulf Coast spill represents another crisis too important to waste, then it's also one that is too important to relegate to unfocused wishes for an oil-free world within the next few years. The best "use" of the spill is to convene a concrete national conversation on how to provide the US with energy that is as affordable and environmentally-acceptable as we can realistically make it in the in the short, medium and long-term. That will require examining all the trade-offs involved, as well as how the balance between conventional energy and renewables and other alternatives is likely to shift in the years ahead. If that did nothing else but get us clearly focused on outcomes, rather than picking our favorite pathways, then it might constitute a positive outcome from an otherwise miserable episode in our nation's energy history.

FYI, tomorrow (June 2) at 1:00 PM EDT I'll be on a webinar panel hosted by The Energy Collective to discuss the implications of the oil spill for the future of energy. If you're interested, please sign up using this link.