Wednesday, May 23, 2012

Can the US Military Afford More Biofuels?

Last week the US House of Representatives passed the fiscal 2013 National Defense Authorization Act by a wide, bi-partisan margin. It included two controversial provisions relating to energy that will presumably be debated when the Senate Armed Services Committee takes up the bill this week.  Sections 313 and 314 would exempt the Department of Defense from a provision of the Energy Independence and Security Act of 2007 (EISA) barring the government from purchasing alternative fuels with higher emissions than conventional fossil fuels, while prohibiting the purchase of any alternative fuel that costs more than the conventional fuel it would replace, except for testing and certification purposes.  If enacted, the bill would require drastic revisions to the current alternative energy strategies of the US military branches. 

It would be easier to attribute these provisions to partisan maneuvering, if our economic and fiscal circumstances hadn't changed so dramatically subsequent to the passage of EISA in 2007.  Although I don't dismiss the influence of election-year politics in such matters, we are now in the third full year of a recovery so weak that many Americans still think we're in a recession, and we face deficits and a ticking debt bomb that forced a reluctant Congress to agree to deep spending cuts starting next January.  Nearly $500 billion of those cuts are targeted at military spending.  Moreover, our perspective on US energy security has been altered by the emergence of shale gas and so-called "tight oil", and by our recent shift from net importer to net exporter of petroleum products--though certainly not of crude oil.  While it remains desirable for the US military to diversify its energy sources, the value of that diversification has arguably fallen.  Meanwhile, the biofuels industry, despite tremendous growth and advances, has been unable thus far to compete with petroleum-based fuels without either large subsidies or strict mandates, even with a global price of oil that has remained consistently above $100 per barrel since January 2011. 

Last year I had a couple of opportunities to question Defense Department officials about their alternative energy strategies, as part of an Army/Air Force energy forum and a subsequent Air Force media briefing at the Pentagon.  Although I was impressed by the changing military culture concerning energy and the methodical way they were approaching the introduction of new fuels, I was concerned that at some point the services' procurement of higher-cost renewable fuels would conflict with their other priorities, including the need to replace equipment worn out in Iraq and Afghanistan and to field the next generation of aircraft and naval vessels.  What I thought I heard very clearly from the Air Force Deputy Assistant Secretary for energy was that his service was not going into the fuel-production business, and would only buy renewable fuels--other than for certification with their fleet--if they were competitive with conventional fuels. That approach seems very different than the one embodied in the Navy's "Great Green Fleet" initiative.

The rationale behind the military's adoption of alternative fuels rests on many complex issues, including the vulnerability of military supply chains and budgets to potential disruptions in oil supplies and price spikes, consistency with the government's imposition of renewable energy mandates on the private sector, and the desirability of reducing the environmental footprint of the military's global activities.  There's also the human dimension of personnel put at risk delivering fuel to front-line units, although it's not clear how biofuels would alleviate that risk unless they were produced in forward locations. In any case, however, all these concerns must be reconciled with a realistic response to budget constraints. That looks extremely challenging, and it shouldn't be divorced from deeper questions about the evolving drivers for biofuels or other alternative fuels for the US military.

Consider the question of supply disruptions, for example.  US oil production looks set to continue increasing and oil imports to keep falling, while we now enjoy a refining surplus that is supporting new product exports.  We also have a Strategic Petroleum Reserve that could replace up to half of our net crude oil imports for up to 5 months, or a smaller disruption for much longer.  As a result of these factors, it's become more difficult to envision a scenario in which an oil market event affected the military's access to fuels in a manner that the present renewable energy industry could alleviate.  And with the cost of most alternatives still above even today's elevated prices for oil and its products, the investment required to develop an alternative fuel industry capable of making a meaningful dent in the military's needs under such a scenario would be very substantial.  Should the military make that investment, should someone else, or should it be left to the market?  And that doesn't begin to address the issues related to the non-renewable alternative fuels that would be enabled by Section 313, including synthetic fuels derived from natural gas or coal, though these would still be subject to the restriction that they must be price-competitive with conventional fuels. 

I suspect that the House bill will not be the last word on this subject, though I also imagine that in the new world of "sequestered" budgets and the fiscal challenges that lie ahead, the US military may need to rethink what can be achieved in this area without sacrificing readiness and combat capabilities. It's also important to note that the 2013 Defense Authorization Act's provisions on alternative fuels shouldn't affect the services' efforts to integrate renewable electricity generation, which looks like a real boon for some forward-deployed applications.

Friday, May 18, 2012

E15's Problems Are Symptomatic of A Failing Biofuels Policy

A new report on automobile engine durability casts further doubt on the compatibility of mid-level ethanol blends such as E15 (15% ethanol, 85% gasoline) with the existing US light-duty vehicle fleet. The report was issued this week by the Coordinating Research Council (CRC) under the auspices of API, Global Automakers, and the Alliance of Automobile Manufacturers.  It found that at least some of the vehicles included in EPA's certification of E15 for use in cars manufactured since 2001 experienced excessive valve wear and other mechanical problems over the course of a simulated engine lifetime.  Together with previous research highlighting the risks of E15 for gas station pumps, the report's findings raise serious questions about the federal government's current ethanol policy and who will ultimately bear its hidden costs.

I've written extensively about the EPA's approval of E15 for use in vehicles and the underlying rationale for increasing the ethanol content of most gasoline beyond the 10% limit (E10) for which most cars on the road today were designed.  At current volumes, domestically produced corn-based ethanol accounts for roughly 10% of all US gasoline and displaces the energy equivalent of 600,000 barrels per day of imported petroleum products.  However, without increasing the amount of ethanol blended into each gallon of gasoline, and in the absence of a miraculous transformation in the public's minuscule appetite for E85 (the 85% ethanol blend sold for flexible fuel vehicles) the US ethanol strategy has hit its natural limit.  Since US gasoline consumption, which prior to the recession routinely grew at 1-2% per year, has stalled at a level comparable to what we used ten years ago, the enthusiasm of the US ethanol industry for E15 to expand its market is entirely understandable.

The CRC's results have been criticized by both the ethanol industry and the Department of Energy.  Although I don't have the background to judge CRC's report assumption by assumption and result by result, it does appear that many of the criticisms raised by the DOE were addressed in the body of the report, including the choice of ethanol-free gasoline as the reference fuel.  As for complaints that the auto and oil producers have a vested interest in making E15 look bad, ethanol producers are at least as conflicted for their part.  Moreover, without impugning the integrity of the fine folks at the DOE, the federal government also has a significant conflict of interest in this matter: The administration and its cabinet agencies are stewards of a 2007 national biofuels policy that now depends on the adoption of mid-level ethanol blends like E15 if it is to have any chance of reaching its goal of 36 billion ethanol-equivalent gallons per year by 2022, from around 15 billion gallons per year today.  The apparent damage to some engines running on E15 under test conditions similar to those used by the car manufacturers for their own product testing highlights risks that must be addressed before consumers should be asked to put this fuel into their cars.

In addition to concerns about the safety of this fuel for the mechanical integrity of the tens of millions of vehicles for which the EPA has approved it, including both of my family's vehicles, E15 still faces substantial practical obstacles to its widespread distribution--obstacles that will likely require significant new federal funding to overcome. My industry contacts tell me that gasoline retailers considering selling E15 must install brand new gas pumps, because the nationally recognized testing laboratories like UL won't certify existing product dispensers for use with E15.  Anyone who ignores this requirement faces serious liabilities and could end up in violation of local fire codes.  So not only would retailers selling E15 instead of E10 be excluding a large portion of their existing market--at a minimum all pre-2001 cars--but they would have to make significant investments to do so.  Such investments are unlikely to be repaid by higher prices for E15 than for E10, because if anything, E15 should sell for a discount to E10.  Its nearly 2% lower energy content than E10 would translate into a requirement for roughly one extra fill-up a year for the average driver, or a penalty of about $37 per year at current prices.

There's an obvious solution for the risks that the administration is asking motorists to take on with E15 fuel.  Since neither vehicle manufacturers nor fuel retailers are prepared to accept the liability for excessive engine wear or fuel system damage from using E15 instead of E10 or purer gasoline--a position the Congress is considering granting statutory protection--the federal government should step up to this role.  The DOE and EPA claim E15 is safe for cars.  In the private sector, such claims would have to be backed up by warranties, explicit or implied.  Why should this situation be any different?  The President should therefore instruct DOE and EPA to carve out a portion of their annual budgets--after cuts--to fund a new federal warranty program for vehicles damaged by E15.  If these agencies are unwilling to stand behind their assessment of E15, then perhaps this fuel is not as ready for prime time as they suggest.  In any case, foisting this liability on consumers would represent a hidden and likely regressive new tax.

Wednesday, May 16, 2012

Are Chesapeake's Problems A Red Flag For Shale Gas?

Chesapeake Energy has been in the news a lot, lately, concerning both the significant challenges it faces in financing its ambitious development program, and its high-profile CEO, who was recently forced to relinquish his role as Chairman.  The company's stock is trading for half its value one year ago and less than a fourth of its 2008 peak.  Chesapeake is the second-largest producer of natural gas in the US after ExxonMobil, and probably the company most associated with the shale gas revolution, yet it is struggling.  I wouldn't be surprised if skeptics regarded the firm's travails as a warning that the transformative potential of shale gas for the US has been oversold.  However, in evaluating that concern it's important to distinguish among the physical resource, the economics of the industry, and the unusual business model of this one company.  Investors and policy makers may not share the same perspective on these issues.

Start with this key fact: If Chesapeake is in trouble, it isn't because the gas resource isn't there or can't be exploited profitably at a reasonable gas price.  We'll come back to that.  Fundamentally, Chesapeake is on the wrong side of a historic divergence between US crude oil and natural gas prices, and it is playing catch-up to get on the right side of that spread.  This is the downside of natural gas that is trading for the equivalent of $15 per barrel when the global crude oil price--and the price of the most valuable US crude--is still over $100 per barrel.  That relationship is great for US energy consumers but lousy for US gas producers.  It's particularly difficult for Chesapeake, because the company has embarked on a strategy of reducing its focus on natural gas and increasing its production of liquids--crude oil and natural gas byproducts like pentane, butane and propane.  That shift requires significant new investments at a time when the cash flow from its core gas properties has fallen off, despite steadily increasing output.  It also doesn't help that Cheseapeake began this strategic shift later than competitors like EOG Resources.

Chesapeake's problems are further complicated by its business model, which has focused on finding and proving resources and then selling them down to fund the next big project.  Consider transactions such as last year's sales of one-third interests in Chesapeake's Eagle Ford and Niobara shale holdings to China-based CNOOC for around $1.6 B plus a substantial share of development costs. This isn't your father's gas company.  But with natural gas prices so low--even a year out they're still only equivalent to $20/bbl--its existing portfolio of gas assets is worth less to potential buyers.  Other companies such as BHP that have bought shale assets in the last couple of years are reportedly considering write-downs.  As a result of these market conditions, Chesapeake is apparently looking at a variety of new funding opportunities, including selling interests in oil-bearing properties and pre-selling production streams. 

I don't have an opinion on whether they'll navigate these rapids successfully or not. I'm not in the business of providing investment advice to my readers, nor do I have any financial interest in Chesapeake.  My interest here is in the implications of Chesapeake's dilemma for the larger US energy situation.  The current low natural gas prices are clearly putting a lot of stress on independent producers, including the majority that have much simpler business models than Chesapeake's, based on acquiring leases, producing gas, and generating revenues that exceed their costs.  If low prices persist, then a lot of producers could be in deep trouble, and some of them won't make it.  That's the risk they took.  However, the more salient question is what all that means for US natural gas production, which last year broke the production record set in 1973, when we produced 60% more crude oil than today.  Could an industry shakeout lead to lower US natural gas production?

One indicator is that drilling for gas has already slowed significantly.  According to Energy Information Agency statistics, the number of exploration and development wells targeting gas is down sharply, while those pursuing more valuable oil are up.  Sometime soon that switch should be reflected in output trends, though because of the higher productivity of shale gas wells actual gas production may not decline before demand picks up.  In its latest investor presentation Chesapeake forecasted producing nearly as much gas in 2013 as last year, despite its big shift to liquids.

As odd as it may sound, the future trajectory of US gas production likely depends on a race between potential supply and potential demand, both of which are enormous.  The oil & gas industry hasn't seen the likes of this since the 1980s, and perhaps not since the early 20th century. Today's shale gas output is just scratching the surface of a new resource conservatively estimated at 482 trillion cubic feet (TCF), or 96 times 2010's shale gas output of 5 TCF. Meanwhile, gas is already eating coal's lunch in the utility sector, reducing the latter's share of electricity generation by about 6 percent of the market in the first two months of this year, compared to 2011.  The opportunity in transportation is even larger, though clearly more difficult to exploit, because of infrastructure and fleet investments.  Chesapeake seems to understand this, given the money it's investing in market development, on both advocacy and specific projects to turn gas into transportation fuels or use it directly in cars and trucks.

If natural gas could be stored and shipped as easily as oil, the current oversupply wouldn't be a problem, nor would domestic producers be forced to pace their expansions to match the growth of demand or exports.  However, gas producers have always had to develop major new resources in tandem with markets, with that discipline often enforced by price, as we are seeing today. Time will tell whether Chesapeake expanded too rapidly, or like so many others merely missed the warning signs of the recession and financial crisis that hobbled demand growth at just the wrong time for them.  Yet no matter how their story turns out, the fate of US shale gas is not dependent on the fortunes of a single company, and there will be plenty of larger, better-capitalized players waiting to snap up the assets of any first-generation shale gas producers that don't make it.  That's because no matter how challenging today's low prices are for producers, the prices that prevailed just a year or two ago were adequate to support the growth of both production and new demand.  

Wednesday, May 09, 2012

Where Gas is Already $10 per Gallon

I've just returned from a business trip to Norway.  One of the first things I noticed upon my arrival there, on the way into town from the airport, was the price of gasoline.  Since Norway still uses its own currency rather than the Euro--lucky them--I had to look up the exchange rate before I could calculate that 15.40 Norwegian Kroner per liter equated to a penny or two under $10 per gallon. I'll bet that Norwegians would be ecstatic if it were only $4 a gallon.  Gasoline isn't the only thing that's expensive in Norway--a draft beer was $9--but the remarkable thing about its price there is that, unlike nearly all European countries, Norway is a net exporter of both oil and refined products, including to the US.  Most major producing countries subsidize motor fuel for their populations; Norway taxes it exorbitantly and effectively puts the proceeds into its Government Pension Fund

As a result, there's at least one developed country that is well-positioned to manage its public pension liabilities.  Although I wouldn't advocate adopting exactly the same system here, since among other differences we're still a significant net importer of crude oil--despite the weak economy having made us a net exporter of products--it does suggest some possibilities.  Could Congress compromise on opening up more US oil and gas resources for development if the royalties were slated for infrastructure investment or a new Social Security trust fund that amounted to more than just an accounting exercise involving government paper?  It's an interesting model to contemplate.

Thursday, May 03, 2012

Resources from Space?

Last week a company called Planetary Resources, Inc. announced its intention to develop the means of exploiting minerals from near-earth asteroids on a for-profit basis.  This news got some attention for its novelty, particularly at a time when the concerns of most companies are distinctly earthbound.  It also attracted sneers from some in the financial press, though the author of a particularly scathing analysis in the Financial Times seems to have confused recovering material on the scale of a NASA space probe with the kind of large-scale mining that Planetary Resources contemplates.  I don't know whether there's a pony in there or not, somewhere down the road, but there's certainly a larger message to be gleaned: The company's announcement serves as a useful reminder that the earth we live on is not a closed system.  Anyone interested in truly long-term sustainability must take account of that. 

Every aspect of our lives is affected by energy received from outside the earth's atmosphere.  Other than nuclear, geothermal and tidal power, all our energy sources make direct or indirect use of sunlight that has been stored via photosynthesis or redistributed by the atmosphere and the hydrolologic cycle.  And at least some of the resources we use arrived here during the bombardment this planet received from space in its early stages.  You can carry that logic all the way to Carl Sagan's memorable comment that we are "made of star stuff." However, my main interest in this--and apparently that of the impressive list of staff and investors in Planetary Resources, Inc.--is on a practical, rather than philosophical level.     

Start with the negative side of the ledger, which reminds us that although greatly diminished, the bombardment of earth from space still continues.  A chapter in Neil deGrasse Tyson's latest book, "Space Chronicles", includes a sobering chart on the scale, relative damage, and frequency of impacts large enough to merit a comparison to nuclear weapons.  As the Spacewatch project has documented, the volume of space through which we orbit the sun is not nearly as empty as we'd wish.  Sooner or later we or our descendants will need capabilities such as those the Planetary Resources folks hope to develop--not for mining but to move a big rock like Apophis out of our way.  Tackling climate change won't matter much if a nasty like that drops into the Pacific Ocean or turns part of a continent into dust.  Dealing with low-probability, high-consequence risks is never easy, as we've learned to our regret in the last few years.

On a more positive note, the resources available in space are enormous, though at this point the cost of capitalizing on them is even larger.  If that gap is ever to narrow, it will happen through the efforts of groups like Planetary Resources.  Pure science only takes you so far, and building defenses against a global threat that might not materialize for a thousand or a million years is unlikely to galvanize governments that aren't even sure how to navigate the next year or decade, yet.  But getting rich remains a pretty reliable motivation. If someone succeeds in overcoming the numerous obstacles that an effort such as that described on the company's website faces, rich won't begin to describe them.

Pursuing an opportunity like this isn't a substitute for addressing our present challenges on earth.  My long-time readers know that I'm very interested in--and was even briefly involved in--space solar power. Its potential  is also enormous, but that doesn't mean we should stop drilling for the hydrocarbons we'll need for the next several decades, while developing the renewable energy sources and other technologies that will help to reduce our greenhouse gas emissions. Space solar power isn't a bridge to a future energy technology; it's the kind of technology toward which we need a bridge.  I view space resources in much the same light.  We talk a lot about the impact on the climate a century from now of the emissions we're producing today.  Why wouldn't we also plan for the resource base that the world of the late 21st century might need, unless we expect our descendants to be many fewer in number and so frugal that they consume less per person than the citizens of today's least developed countries?  That vision might appeal to some environmentalists, but it doesn't appeal to me.

Planetary Resources faces huge risks, not the least of which are the customary ones faced by any startup.  MIT's Technology Review has a thought-providing article on the difficulties that energy startups face today, and many of the points it makes would also apply to a space development company. It's not entirely irrelevant that the company's announcement came in the same month that one of our last space shuttles was flown to its new home in the Smithsonian's Udvar-Hazy aerospace museum not far from where I live. In order to succeed they must do something no one else has done before, in an environment as unforgiving as any that humanity has faced.  Yet while I'm not in a position to bet my retirement savings on an idea like this, I'm very glad that some of those who have made their fortunes starting companies in other industries are willing to wager a portion of their wealth on this proposition.  In the slim chance that they win their bet, it will change the world.