Tuesday, April 29, 2008
It is a reflection of the degree to which US fuel supplies are integrated into the global market--and of how stretched those supplies have become as a result of sustained high global demand growth--that a problem at a medium-sized refinery in Europe might affect what US consumers pay for gasoline and diesel fuel. Because our refinery capacity has not kept pace with demand growth, the US imports an average of over a million barrels per day (bpd) of gasoline and gasoline blending components, and another 300,000 bpd of diesel and heating oil. That means our prices must be high enough to compete for those supplies against other fuel importers. When a refinery shuts down in the UK, drawing in imports from the Continent, there is less gasoline available to export to us, and the EU's rising imports of diesel increase even more. With "gas oil" on the London exchange selling for the equivalent of $3.50/gal., compared to $3.27/gal. for diesel fuel in New York Harbor, I wouldn't be surprised to see traders export a few cargoes of diesel to capitalize on that arbitrage opportunity, exacerbating tight US diesel supplies.
The one break that US consumers have caught this spring is that weaker gasoline demand has pushed down refining margins, reducing the difference between crude oil and gasoline prices to historic lows and providing a bit of insulation against the full impact of $115 oil. Comparing March-April of 2008 to the same period in 2006 and 2007, the NYMEX "gas crack"--the spread between gasoline and crude oil prices on the New York oil futures market--has averaged about 35 cents per gallon lower in a portion of the year when refinery output is usually constrained by annual maintenance, and demand is building towards its summer peak. The first-quarter results of companies with a large exposure to the US refining sector, including Valero and ConocoPhillips, tell the same story.
With crude oil as high as it is, the last thing standing between us and $4-average gasoline is unusually weak refining margins. It wouldn't take a very large disturbance to shift margins back into a more typical seasonal pattern. We should thank the management and workers of the Grangemouth refinery for resolving their dispute quickly and helping to forestall that outcome, at least for now.
Monday, April 28, 2008
I don't question that the MicroFueler designed by the founders of E-Fuel Corporation is a very clever machine. For ten grand, you will be able to purchase an appliance that turns sugar and water into 200-proof ethanol, at a cost somewhere between $1.00 and $7.00 per gallon, depending on how cheaply you can source the sugar. That doesn't include the cost of converting your automobile to run on pure ethanol, if it's not already a Flexible Fuel Vehicle (FFV). Now, who could fail to see the appeal of this: saving money, gaining freedom from oil and its emissions, becoming self-sufficient, and reducing one's impact on the planet? Unfortunately, on further inspection most of these attributes turn out to be illusory, or at least severely compromised.
Start with the implied energy independence angle, which has been a key driver of the entire biofuel movement since its inception. The problem in this case is that the US is already the second-largest importer of sugar in the world, despite sugar imports being restricted by the federal government, in order to maintain a high price for domestic producers. As a result, bulk duty-paid sugar prices hover around 20 cents per pound, and the retail price is over 50 cents. But while our national sweet tooth seems insatiable, our fuel consumption is even more so: turning 100% of current US sugar imports into ethanol would only yield as much fuel as a couple of commercial-scale ethanol plants, a few hundred million gallons per year in a fuel market of 142 billion gallons. Turning sugar into gas might free an individual from the weekly trip to the gas station, but it wouldn't do a thing for the US trade balance or energy deficit.
Next, consider the economics. Using the article's low-end estimate of 10 pounds of sugar for each gallon of ethanol produced, even bulk-price raw sugar would yield an ethanol cost of $2.00/gal. And although it's possible to design an internal combustion engine that is optimized to get the most out of ethanol's unique fuel properties, including its very high octane rating, such engines are not under the hoods of our cars, whether they are FFVs or not. That leaves pure ethanol with a 30% energy content and fuel economy disadvantage relative to gasoline, boosting the gas-equivalent cost of the MicroFueler's home-brewed output to $2.87/gal. That might look pretty good compared to last week's national average retail price of $3.51/gal., but even at $4.00/gal. it would take the average motorist 17 years to pay out a $10,000 investment in home fueling, ignoring the financing costs and the time value of money. If gas prices fell back just to last year's average of $2.84/gal., the return on this investment would be negative.
The environmental benefits don't look compelling, either. While ethanol sourced from sugar cane produces significantly fewer lifecycle greenhouse gas emissions than ethanol derived from corn and other grains, recent studies suggest that much of that benefit is offset, when virgin land is cultivated to expand output. And although the inventors claim to have produced a device with higher efficiency than some bulk ethanol production plants, it's not obvious that this efficiency edge would hold up, when the emissions and energy consumption of sugar refining and transportation are added to the equation.
I hate to pick on a couple of entrepreneurs who probably see themselves addressing a critical need, and hope to make an honest buck in the process. This impulse is in the best tradition of American capitalism. But good intentions don't necessarily equate to sound decisions and wise policy. Prominent environmentalists are now calling for an urgent reevaluation of our entire national strategy of crop-based biofuel, and of the Renewable Fuel Standard, in particular. And while food vs. fuel competition is hardly the sole culprit in recent global and US food price inflation, it is clearly an important contributor. Changing the scale of the means of converting carbohydrates into fuel doesn't alter the underlying pitfalls of the basic idea of putting food in our gas tanks. In this context, home production of fuel ethanol is a good example of an option better left unexercised: something we could do, but shouldn't.
Friday, April 25, 2008
There are many reasons why a producer might want to integrate into the distribution and marketing of its products, and they vary with the conditions of the market in which it operates. The relatively recent integration of the leading US refiner Valero into branded marketing probably had more to do with gaining access to a less cyclical and non-correlated source of profit margins than with any concern that it would be unable to sell its output into the market. From the account of the Cosan/Esso Brasileira transaction in this morning's Wall St. Journal, however, the impetus for this deal seems to be one that would have been well understood by the founders of today's major oil companies, who operated in a similar period of rapid market growth, product oversupply, and cut-throat competition in this country.
Despite frequent and sometimes breathless comparisons to the success of ethanol in Brazil, the US produces more ethanol from corn than Brazil does from cane: 6.5 billion gallons last year, compared to around 5 billion. But the critical difference is that, while ethanol in Brazil enjoys a much higher share of the domestic motor fuels market, there is also a surplus, leading to substantial exports to the US and other countries. Producing ethanol from sugar cane in the tropics is so efficient that Brazilian ethanol can, without any government subsidy, overcome the $0.54/gal US ethanol import tariff--a necessary element of our domestic ethanol subsidy structure. That means that ethanol producers in Brazil must compete aggressively to supply the domestic retail fuel market controlled by Petrobras, Ipiranga, Shell, Chevron's Texaco brand, and Esso.
Buying Esso's marketing and distribution network should provide Cosan with a dedicated outlet for its entire 330 million gallon per year ethanol output. However, the world has changed since the days when energy companies regarded their marketing arms as a mechanism for locking in upstream profits--a means of "disposal". Cosan is effectively buying an option that it will choose how to exercise every day, pushing its product into its own stations or buying from other producers and continuing to export to other markets. Whether local marketing margins are low or high, it will be able to optimize around its new value chain and enhance the profitability of its core sugar cane business.
Some will wonder whether this deal foreshadows a future move by a US ethanol producer to build or buy its own retail network, to push E85 into this market. It's possible, but while corn and cane are similar in each having other uses besides fuel production, cane ethanol's much larger energy surplus makes it a valuable energy source, like crude oil, rather than just an energy extender. Corn ethanol is a margin business that hinges on the "crush spread" between a lively commodity market for corn and the mandated, subsidized use of ethanol by gasoline blenders. Efficiency and scale are its key drivers, and that's reflected in the merger of VeraSun and US Biofuels. For now, at least, horizontal integration and consolidation, rather than vertical integration, looks like the trend to watch here.
Note: I have a financial interest in one of the companies mentioned today, Chevron, and none of my comments should be construed as investment advice.
Thursday, April 24, 2008
US emissions of the greenhouse gases (GHGs) implicated in climate change have grown significantly over the last couple of decades. Compared to the Kyoto Protocol's baseline year of 1990, we now emit 14% more. Yet from 2001 to 2006, net US emissions--sources minus sinks--have been essentially flat. Slight rises in 2004 and 2005 were offset by a drop in 2006, leaving us with a net of 6.17 billion metric tons per year of CO2-equivalent emissions. That's still too much, but it's a far cry from the projections of a 35% increase over 1990 levels that I used to see when I tracked this issue for Texaco. And while the EPA hasn't reported 2007 data yet, it's hard to imagine that they would reflect much of a jump, given the increases in energy prices we saw last year. So if US emissions have already stalled, and high energy prices appear likely to keep a lid on them for at least the next year or two, then the prospect of beginning to reduce them seems much more realistic than if they were still growing by 1-2% per year. What could we accomplish by 2025, from our actual starting point of a five-year plateau? I'm not sure, but that seems like a better question to be asking, than how to keep them flat for another 17 years.
Turning to CAFE, the proposed timetable for implementing the 35 mpg standard that was signed into law last December would raise the overall fuel economy of the new car fleet, including SUVs, to 27.8 mpg by the 2011 model year and to 31.6 mpg by 2015. In particular, the average for new passenger cars would have to rise from the current 27.5 mpg annual target to 31.2 mpg by 2011 and to 35.7 by 2015. That sounds quite aggressive, until you realize that the data from the National Highway Traffic Safety Administration, under whose authority the CAFE program falls, show that the 2007 model average passenger car fleet already gets 31.3 mpg. For that matter, based on the sales mix reflected in NHSTA's January 2008 CAFE report, the combined 2007 new car fleet delivered an average of 27.2 mpg. With SUV sales having fallen back below 50% from their 2004 high of 53%, it's a reasonable bet that the shifting sales mix alone would allow the fleet to achieve the 2011 goal without any changes in vehicle performance. In that context, the 2015 milestone goal of 31.6 mpg overall looks more like a 2% per year average improvement over the next seven model years, rather than the 4.5% cited by Secretary Peters.
The conservatism embodied in the new CAFE timeline is at least more understandable than that for GHGs. Designing more efficient car models won't be accomplished overnight, and then factories must be retooled to build them. A standard that pushed too hard at the front end would merely result in larger fines for manufacturers, or a bigger shift to imports. What is less understandable is the hoopla the timeline has generated. Perhaps this is aimed at shaping the expectations of consumers. After all, unless they alter their buying habits to prefer higher fuel economy to ever-higher horsepower, CAFE will merely be an accounting system with a relatively weak enforcement mechanism, rather than a serious means of reducing the annual fuel consumption of America's 240 million automobiles.
Wednesday, April 23, 2008
At the same time, while a correction seems long overdue, I’m concerned that oil has reached its current heights without any major supply crisis, driving the average US retail gasoline price above $3.50/gallon without any serious refining or product distribution problem. An event on either front could send oil prices or refining margins to levels that would quickly translate into another 20-30 cents per gallon at the pump, pushing large parts of the county over the $4.00 mark, which is already appearing at higher-priced retailers in California.
As consumers contemplate that possibility, we should remember that we have more influence over prices than we think. A 0.5 mile-per-gallon improvement in fuel economy from avoiding jackrabbit starts and coasting into stops--rather than accelerating until the last moment—would aggregate to a 6 million barrel per month reduction in demand and ease the pressure on prices, while filling up at ½ instead of ¼ would deplete US gasoline inventories by 10 million barrels, or about 5%. That could make $4 gas a self-fulfilling prophesy.
Monday, April 21, 2008
As an outgrowth of a recent posting on the ongoing fuel vs. food controversy concerning biofuel, a reader provided a link to an article on a recent study suggesting that food type was more important than the proximity of food sources in determining the greenhouse gas (GHG)emissions associated with our grocery purchases. Surprisingly, the study found that only 4% of life-cycle emissions were associated with food transportation, compared to 83% for food production. With all due respect to cattle ranchers, it appears that reducing our consumption of beef would have a much bigger impact on food-related GHG emissions than avoiding foods grown far away, such as all that lovely Southern Hemisphere fruit that turns up during our winter. But while the global impact of such a choice is hardly insignificant, it would still rank relatively low on the overall 80/20 distribution for GHGs.
The inventory of US GHGs provides a clear hierarchy of priorities for reducing emissions. While the methane emissions from cows contribute more to climate change than cement manufacturing--widely viewed as a highly GHG-intensive industry--and actually make the top-10 of individual sources, they still pale in comparison to fossil fuel combustion. Here is the list, taken from the EPA's 2006 statistics, with some obvious combinations of line items, such as including the methane emissions of natural gas systems in the "Industrial/Commercial" fossil fuel category, and adding manure management and "enteric fermentation" to get "Animal Husbandry":
True to our friend Pareto, the combustion of fossil fuels, along with other uses of them such as asphalt roofing and paving, account for 80% of our total GHG emissions--81.7% if you include the methane emitted from coal mining. The next five sources contribute 11.8%, and everything else, including iron and steel production, cement, and the entire chemical industry, tally to only 6.5% of our total emissions of 7 billion metric tons per year of CO2-equivalent gases. No other single line item exceeds 1% of the total.
That doesn't mean that the smaller sources are unimportant, particularly if they offer quick and easy opportunities for reducing emissions. However, it does mean that we can't solve the challenge of climate change without making enormous cuts in our consumption of coal, oil and, to a lesser degree, natural gas, and by extension in the fuel and electricity that we produce from them. No other rational interpretation of the data is possible. Achieving the Kyoto Protocol's US target of 7% below our 1990 emissions would require eliminating the equivalent of all current emissions from commercial and industrial uses of fossil fuels, while the 50-80% reductions mooted in various domestic cap & trade proposals could only be attained through the massive transformation of the entire energy sector, and indeed of most of the US economy.
Some suggest we can do all this in a manner that will pay for itself, creating new, high-paying industries in the process. As an optimist, I hope they are right; as a realist, I anticipate that we will encounter many painful bumps along the way, some of which might exceed the upheaval we are currently experiencing from the sub-prime crisis. In that sense, our current economic woes provide a useful test of our ability to tackle a problem on the scale of climate change with pragmatism and resolve, rather than with measures that place a higher priority on the appearance of action and the protection of key political constituencies. An effective response to climate change will also require the kind of persistent bi-partisanship with which we approached the Cold War, spanning multiple congressional sessions and presidential administrations. These might be useful criteria to keep in mind not just on Earth Day, but on Election Day.
Friday, April 18, 2008
Although imports of LNG have become an important balancing mechanism within the last decade, they still account for only 3% of the 23 trillion cubic foot (TCF) per year US natural gas market, dwarfed by the 14% of supply provided by our net imports by pipeline from Canada. As the Journal noted, the use of gas to fuel electricity generation has been growing at a faster rate than any other large segment of demand, at a compound average growth rate of 4%. With US gas production only recently recovering from a multi-year decline, it is fair to say that the increase in power plant gas use has been facilitated by LNG imports and by the destruction of significant quantities of industrial demand, with attendant job losses.
As US gas demand grows, LNG will play a larger role, and so the expansion of the international market for gas is good news. However, whether that also results in higher US prices for natural gas is as much a function of US policies as of the global marketplace. While it's true, as the Journal mentioned, that companies such as Chesapeake have been very successful increasing gas output from non-conventional sources, including shale and coal-bed methane, it remains equally true that federal and state drilling bans are keeping hundreds of TCFs of gas off limits, leaving the US to choose between restraining demand or increasing imports. If that story sounds familiar, it should, because it's precisely how we got into our current dependence on oil imports. Natural gas was one of the pillars for restoring energy security after the energy shocks of the 1970s, but if we're not prudent, in a decade or two we will be lamenting the high degree of US vulnerability to our LNG suppliers, just as we now bemoan our dependence on foreign oil suppliers.
The other point I'd like to leave you with concerns gas's large BTU discount versus crude oil, approaching 50% at yesterday's NYMEX futures prices. The Journal suggests this may be viewed by investors as an attractive speculative opportunity--one bubble inflating another, perhaps? While I agree that this price difference looks too large to persist indefinitely, it is not intuitively obvious that it will correct in only one direction. Although the value of gas relative to coal should continue to trend upward, reflecting its lower emissions of greenhouse gases and local pollutants, gas remains much less fungible than oil. Storage options are fewer, and long-distance pipelines and LNG supply chains are built around long-term commitments, not momentary arbitrage opportunities. Caveat emptor, indeed.
Wednesday, April 16, 2008
Senator McCain seems to be responding to one of the most common complaints in today's economy. This week's average US retail price of $3.389/gal. for unleaded regular gasoline is $0.59 higher than the average for 2007, and diesel is $1.12 higher than last year. Waiving the 18.4 cent per gallon federal gas tax and the 24.4 cpg diesel tax would cost the Treasury $9.5 billion, based on last summer's gasoline and diesel volumes. The tax holiday would provide the average driver with a total benefit of about $25, assuming that 100% of the tax cut would be passed on, an outcome that seems optimistic in light of the way the tax is collected.
Under the IRS code, gasoline and diesel are taxed when they leave the distribution terminal in a tank truck or railroad tank car, not when fuel is pumped into your car. If the retail facility is owned and operated by an integrated oil company or a large refiner or distributor, there's no practical difference. But if you buy from one of the country's tens of thousands of independent retailers, the tax is already included in the charges collected by the supplier from the retailer when a truckload of fuel is dispatched to the station. In that case, waiving the tax reduces the payment to the supplier, but it does not guarantee that the retailer will reduce the pump price accordingly, even though the retailer technically only sets the "pre-tax" price.
In the short run, the strongest pressure on retailers to pass on the full effect of a fuel tax holiday would come from the other local stations with which they compete, rather than from their suppliers. So while company-owned and operated stations would likely cut their prices by the full amount of the tax from day one, because of their higher visibility, I wouldn't be surprised to see some retailers initially retain some of the savings, to improve their margins. They're in a tough business, and the temptation would be understandable. Competition would gradually dampen that urge, but we routinely see wide local variations in the retail price of gasoline, which can be as large as $0.50/gal. for the same grade in some markets. A tax cut might amplify those spreads.
Over time, and without any changes in the price of crude oil, gasoline prices would tend to drift back up. Lower prices would stimulate demand--or at the current level it's probably more sensible to think of them reducing demand by less than they would without the tax holiday. More demand means more truckloads dispatched from terminals to service stations, and that signal shows up on the desktop of company pricing managers. It might take longer than three months for this process to displace the entire amount of the tax cut, but by the end of the summer enough of it would have been eroded that when the tax was reimposed after Labor Day, prices would end up higher than they would have been without the cut. It might take several weeks for market forces to compete away that spike.
While consumers would certainly see some benefit from a summer-long suspension of the federal tax on gasoline and diesel fuel, a portion of the savings would stay in the pockets of independent retailers, who would be under less scrutiny to pass on the full tax cut than the major oil companies. Then in September at least some of the benefit would be given back, while the market adjusted to the restoration of the tax. On balance, and ignoring the policy concerns raised by this proposal, it might be simpler and more beneficial all around to send every American a $20 bill and call it a fuel tax rebate.
Tuesday, April 15, 2008
A couple of fundamental changes in the dynamics of global oil supply and demand have created a situation in which it is very difficult to tell whether the oil market is dealing with the consequences of geology, or of economics and geopolitics. The April 11, 2008 Oil Market Report from the International Energy Agency includes a useful sidebar discussion on a key aspect of this, the disappearance of a large cushion of global production capacity. As recently as 2002, spare crude capacity stood at around 7 million barrels per day (MBD), or nearly 10% of demand. Today's cushion of around 2 MBD, less than 3% of demand, has been a major factor in higher oil market volatility and prices. In the course of five years, the rapid growth of demand in Asia and the Middle East absorbed 5 MBD of spare capacity, and the constraints on access and the competing demands on the world's engineering and construction capacity make it very difficult to rebuild that margin of comfort. The IEA refers to this as "just-in-time capacity", and it certainly doesn't appear to be in OPEC's interest to shift out of that mode, even if they could.
When I first started blogging on the topic of Peak Oil in 2004, the rationale for this phenomenon was rooted firmly in the geology of oil basins and the statistical distribution of the size, age and decline rates of the world's oil reservoirs. While that still forms the core of the Peak Oil narrative, it has expanded to encompass concerns that I saw then--and still see now--as likely to overwhelm the geological constraints on oil production: limitations on access by oil companies to the most prospective oil geography, including known deposits that are off-limits for geopolitical or environmental reasons; the shifting demographics of the industry, including the maturing and shrinking workforce of the investor-owned oil companies; and the time-lags and capital- and project-management challenges involved with queuing up new production from large conventional and unconventional sources. As a result, the version of Peak Oil that I encounter most frequently, in comments I receive on this blog and in the articles and blogs I read, sums up all these factors to predict an imminent stall-point in the long, upward trajectory of global oil production.
This would be fine and good, if there weren't a fundamental difference in the possible outcomes of the disparate views that have been absorbed into today's notion of Peak Oil. If what we are seeing is the onset of true geological limitations on oil production, with the decline of existing fields beginning to overwhelm the fastest rate at which new--and generally smaller--fields can be brought onstream, then no change in policies, economics or geopolitics will alter the outcome: less oil within a few years than we have today, and prices that will make yesterday's $111/bbl look like a bargain. If, on the other hand, we still have another 10-20 MBD of potential growth before we reach such a point, then OPEC and non-OPEC producers could continue to eke out just enough incremental output each year to keep pace with the growth of demand--expected to add another 1.7 MBD of consumption this year--but without restoring any of the lost spare capacity. That implies continued market volatility and price increases, but without the exponential spikes that would result from permanently stalled global oil output.
Now, why should this distinction be of more than merely academic interest? First, if we are indeed entering the outer suburbs of Peak Oil, then we are about to discover just how tardy we have been in our preparations. Energy efficiency and alternative transportation fuels take time to ramp up, and that interval may last longer than the residual upward trend in oil output can sustain us. Prices would then have to rise by enough to destroy a couple of million barrels per day of existing, rather than potential, demand every year. At the same time, belief in the likelihood of this outcome--whether correct or not--by an increasing number of oil market participants rules out for them the possibility of a drop in oil prices back towards a realistic floor--somewhere around $60/bbl, based on the actual cost of incremental supply--that might otherwise deter unbridled speculation in oil commodities. In other words, whether or not we are truly on the threshold of Peak Oil, the more that people believe we are, the higher oil prices will go, even if that's not justified by the market's fundamentals. Only the passage of time will reveal which interpretation is correct.
Monday, April 14, 2008
It's not unusual for advocates of an urgent response to climate change to treat such questions of international and inter-generational environmental equity as though the solutions were glaringly obvious. Yet when I assess the conflicting considerations involved, they look anything but simple. Because most greenhouse gases persist in the atmosphere for decades, with a few of them lasting thousands of years, historical emissions will affect the climate for many years and are thus clearly relevant to any allocation of responsibility for mitigating emissions. But emissions alone don't tell the whole story, without including widespread changes in land use that have altered the earth's ability to absorb both natural and man-made emissions. Including this factor for the period from 1950-2000 puts developing countries into a virtual tie with the industrialized nations in term of overall climate impact.
Nor does the inclusion of land-use changes resolve all questions of equity concerning historical emissions. Today's scientific consensus on anthropogenic climate change--widely but still not universally accepted--did not exist prior to the 1980s, and apportioning blame for emissions that predate that consensus seems unproductive. Holding current Americans and Europeans responsible for the consequences of emissions that were generated prior to the signing of the UN Framework Convention on Climate Change in Rio in 1992 seems at least as unfair as asking Chinese and Indians to take as much responsibility for their current and future emissions as developed countries must. While some might see a parallel to the duplicitous arguments of tobacco companies that knew for decades that their products were dangerous, the global warming theories of Arrhenius a century ago hardly count as a "smoking gun." There's legitimate disagreement about the point at which we should have known that fossil fuels and other activities were affecting the climate, but it was certainly no earlier than the last two decades.
Then there's the problem of offshored emissions. With a considerable share of the emissions from Asia's rapid industrialization attributable to products made for export markets in Europe and the US, who should bear responsibility for the CO2 and other greenhouse gases emitted along the way? Producers, who are often making slimmer margins than the retailers selling their output? Consumers, who have benefited from lower prices and thus seen their purchasing power rise, but have also seen jobs sent offshore? While an emissions cap & trade system with accompanying GHG-leveling tariff could resolve this conundrum going forward, by pricing this externality and letting the marketplace apportion it along the value chain, I can't begin to fathom how to allocate the emissions responsibility for the last decade of this phenomenon.
So if it's not fair to include historical emissions but it's equally unfair to ignore them, and with emissions from the developing world rapidly overtaking the developed world's--but including some ultimately attributable to the latter--where can we find middle ground from which to move ahead, together? Not in the past: the only emissions over which we have control are those that haven't occurred, yet. If the negotiations kicked off with the Bali Roadmap are diverted by arguments over history and fail to focus squarely on the output of the world's twenty or so largest emitters between now and 2050, then they will be fruitless, and we will need to shift our attention to more practical matters of adaptation and possible geo-engineering. We should know the outcome of this debate within a year or so.
Friday, April 11, 2008
Yesterday's posting, which was cited in today's WSJ Environmental Capital blog, looked at how oil trading has changed in the last couple of decades, focusing on the tremendous growth in the influence of the New York Mercantile Exchange's West Texas Intermediate (WTI) crude oil futures contract. Because it is the largest and most transparent oil market in the US, it has provided a handy reference point for traders transacting deals for physical oil, often with very different properties of sulfur, specific gravity, and other characteristics. The typical structure of an oil deal now involves an agreed premium or discount to the prevailing WTI price over an agreed period, often related to the time that a cargo of oil is loaded, or a pipeline shipment delivered. So while the global oil market has expanded to some 85 million barrels per day (MBD), with US refineries consuming on average 16 MBD of that, the price for a surprisingly large proportion of those barrels is set by a domestic light sweet crude futures market that is backed by only a few million barrels per day of physical oil: the domestic oil production and suitable imports connected by pipeline to the Cushing, OK delivery point for WTI.
Since current SPR additions are only 0.07 MBD (70,000 bbl/day), how much effect could foregoing them have on oil prices? Measured against 85 MBD, virtually none, but that's not the relevant comparison. What really counts is the Mid-continent light sweet crude system, consisting of pipelines going into and out of storage at Cushing, serving a number of inland refineries, including five sweet crude refineries in Oklahoma with a combined capacity of 0.5 MBD. Thus, while the volume of "paper barrels" traded on the "Merc" can mount into the hundreds of millions of barrels per day, the physical market underpinning them is orders of magnitude smaller. Anyone doubting the disproportionate impact of that system on crude prices need only look back one year, when Cushing was full and the value of the WTI "marker" was in doubt, with the WTI price consistently below that of its UK Brent cousin.
With its three current royalty-in-kind swaps consisting of 58% sweet crude grades, according to a DOE spokesman I contacted this morning, the government has a 40,000 bbl/day lever with which to nudge the balance point of the physical WTI market by reselling the oil that would otherwise go into the SPR. Because that still only amounts to a few percent of actual WTI deliveries, I wouldn't expect the market to drop by $10/bbl. But when you add the psychological impact of the government shifting its stance from buyer to seller--a net swing of 80,000 bbl/day--I wouldn't be surprised to see a change in the speculative logic driving oil ever higher. That ought to knock off at least a few bucks per barrel, while dampening the market's exuberance going forward.
As with climate change, we now see all three remaining presidential candidates signaling a break with the present SPR strategy, starting next January. Unlike climate change, it wouldn't require a change of heart or ideology on the part of the administration to shift from its policy of continuing to fill the SPR above 700 million barrels to putting the government's royalty oil back into the market. That could be done with the stroke of a pen and would be greeted warmly on both sides of the aisle, and by most Americans, with the possible exception of a few hedge fund or commodity fund managers. If it turned out to have no effect, the government could quietly resume SPR additions once its sales contracts ended. With every dollar increase in WTI adding $4 billion per year to our trade deficit and 2 cents per gallon at the gas pump, that looks like a low-risk, high-reward strategy to me.
Thursday, April 10, 2008
Most days I am grateful that I am no longer an oil trader, with one eye always glued to a screen displaying the gyrations of the global energy commodity exchanges. It's not good for one's health, even if you have a calm disposition. That's especially true these days, when a single news item can send the entire market up or down by as much as $4 per barrel from a starting point over $100/bbl. The process was different when I traded crude oil on the West Coast in the late 1980s. Although the NYMEX contract was becoming a bigger factor in the pricing of physical grades of crude oil, such as the cargoes of Alaskan North Slope crude I bought for Texaco's Los Angeles and Anacortes, WA refineries, it was still quite common to buy and sell pipeline quantities of oil at a premium or discount to posted prices--periodically-updated fixed prices at which refiners or traders solicited producers to sell them oil--or as often as not, at a fixed price unique for that deal on that day, e.g., $17.21/bbl for 2,000 bbl/day of Buena Vista Light during April 1987. (It's getting hard to believe oil was ever that cheap.)
Because of the way such deals were struck, a trader and the refinery for which he was buying had to have a very clear sense of the intrinsic value of that oil, either in terms of the products into which it could be refined, or the price at which it could be resold before delivery, if requirements changed. This process involved significant risks that could not easily be hedged, then. The stakes were high enough that, unless the counterparty was a long-term, reliable supplier or customer, deals could fall apart over a difference of 5 cents per bbl. Without suggesting that traders today are any less diligent or astute, I believe a market in which most prices are set with reference to WTI, Brent, or some other ultra-transparent exchange-traded marker entails less accountability for ensuring that the price involved is reasonable, rather than defensible--i.e., "Well, I paid the market price for it."
In a popular film of a few years ago, "Memento," the protagonist had an unusual form of amnesia and woke up each morning without any clear recollection of the previous day. He had to rely on notes he had previously scribbled to himself. What if the oil market worked that way, and each day, traders had to re-establish the price of oil from scratch, relying only on the fundamentals of supply, demand and inventory? A classical economist might suggest that the result would be no different, because the market price is merely the level at which supply and demand are balanced, every day. I'm less sure things are that simple, and I suspect that the practitioners of behavioral economics might be skeptical, as well. For example, yesterday's increase in the price of WTI to $111/bbl in response to an unanticipated 3 million bbl drop in US crude inventories only makes sense if you accept that $108/bbl accurately reflected all of the market factors before that news. However, a similar overall configuration of global inventory and spare production capacity in 2005 yielded prices in the mid-$50s to mid-$60s. $111 makes more sense as the net sum of three years of individual price movements, than as the bottom-up evaluation of all the factors in today's market.
I recently received a copy of an academic paper by a Ph.D. candidate at the University of Michigan and his professor. It tackles the question of whether the oil futures market provides a reliable forecast of future oil prices and finds that it does not. Even my view that it is a good indicator of current expectations of future prices seems shaky, in their analysis. Taken together with my concern that the market may be influenced more by its own price history than it ought to be, I conclude that decision makers, policy makers, and consumers would be well-served to take a somewhat more jaundiced view of that daily WTI settlement price that the media has grown so fond of displaying. Its impact on fuel prices and on our trade deficit is certainly real and tangible, but it might not be telling us as much about the world and the future as we have come to believe.
Wednesday, April 09, 2008
First, at a time when the principal focus of US environmental debate is shifting away from tailpipe emissions of local pollutants--SOx, NOx, etc.--and more to the regulation of greenhouse gas emissions, the California Air Resources Board (CARB) persists in drawing the envelope around the vehicle itself, rather than its entire energy system, and thus its well-to-wheels emissions. That's consistent with CARB's mission; after all, even if they drive super-ultra-low-emission cars, 18 million Angelenos are going to create some smog. Still, the number of annual Health Advisory days in the L.A. Basin, the lowest level of air quality alerts, is now lower than the number of severe Second-Stage Alerts prevailing when I first moved there in the late 1970s. Even though L.A.'s air quality is worse than federal standards, the trend is positive, in spite of enormous population growth over the same period. Isn't it time for CARB to abandon the outdated pollution-shifting rationale behind the ZEV standard and focus mainly on the reduction of lifecycle emissions per mile? Otherwise, they risk fostering such foolishness as cars with internal combustion engines burning hydrogen produced from natural gas, resulting in higher well-to-wheels emissions than gasoline.
It also struck me that the requirement for automakers to produce 58,000 plug-in hybrids per year, starting in 2012, may be too low, rather than too high. I'm no fan of mandates such as this, but spreading that quantity of vehicle sales among a half dozen large manufacturers will likely not result in a profitable model line for any of them. 58,000 cars per year is barely enough for one successful model, let alone one requiring vastly more R&D and retooling than a conventional car. And while Fred Krupp of the Environmental Defense Fund was surely correct in his observation in his WSJ op-ed yesterday that, "a lot of people will make a killing" solving global warming, I think it's equally true--and even more important to note--that our chances of solving global warming will be low, unless there is a lot of profit in it.
Monday, April 07, 2008
Viewed in isolation, the numbers on corn production and disposition tend to support Rep. Herseth Sandlin's perspective that high energy prices could be driving this relationship more than ethanol production. Since 2004, US corn output had increased by a sufficient quantity to accommodate both the expansion of ethanol production and a 30% increase corn exports. And while US corn prices have doubled in this period, the impact of that increase in export markets has been partially offset by the falling dollar. In this respect, the dynamics of corn resemble those that have taken oil from $34 per barrel to over $100 in the last four years: supply is up, but demand is up too, and the rapid growth of Asia has been a significant factor for both commodities, and for many others, as well. If US corn prices were the only thing affected, we might well conclude that this was not a strong indictment of ethanol's value. But just as oil is connected to everything else in the energy economy, so is corn, in the agricultural economy.
Two months ago I cited two studies calling into question the net environmental benefits of grain-based ethanol and other food-derived biofuels. As important as their findings are, their methods remind us that agriculture is every bit as global a business as energy. Its connections involve direct flows of individual commodities, and also strong indirect signals about land use and crop choice. While increased US corn output owes something to improved yields, it is also a function of a shift in acreage to corn from other crops, including soybeans. That sends ripples around the world, particularly when Europe's appetite for biodiesel--in line with its growing preference for diesel cars--is soaking up large quantities of canola (rapeseed,) soy, and other edible oils from all over the world. The impact on cooking oil prices for the world's poor may be an even bigger problem than the global rise in grain prices.
It is not in dispute that higher prices for transportation fuels are contributing to food-price inflation, particularly in the US and EU. The farther food travels from source to supermarket, the bigger the impact of rising diesel fuel prices, which also drive up the cost of cultivation and harvesting. Fortunately for US consumers, the price of natural gas, the primary input for fertilizer production, has gone up by a much smaller proportion than crude oil since 2004. But while energy prices might explain a fair amount of the recent rise in food prices that is pinching the budgets of millions of American families, they don't explain dramatic spikes in the price of wheat and rice in North Africa and Asia. The cost of transportation and energy inputs have less influence on those markets than the competition for acreage between food and energy production.
What we have here, I believe, are two very complex linked systems, one for energy and one for food, into which we are introducing powerful new linkages, on top of those that already existed. Change a parameter in one system--diesel prices, for example--and the other system responds in ways that are only partially predictable. Change a fundamental factor in the other system--the demand for biofuels derived from foodstuffs--and the gears in both systems mesh in entirely new ways, spinning towards an equilibrium we can't even guess at, because they are also both deeply enmeshed in the larger global economy, with its newly-revealed financial complexities. The resulting uncertainties are enormous, creating risks that need to be understood and managed.
In light of the significant questions raised by this recent intervention in global food markets, does it really make sense to double our bet that the impact of biofuels is less than the impact of the petroleum fuels they are meant to replace? At the very least, concerns about food vs. fuel competition, while perhaps overly simplistic, ought to alarm us enough to merit a pause in the efforts of government to ramp up food-based biofuel consumption. Temporarily freezing the US Renewable Fuel Standard at 7.5 billion gallons per year, its maximum target prior to the passage of the 2007 Energy Bill, and capping ethanol subsidies at that volume would buy us time in which to evaluate this problem in detail, without depriving farmers of the benefit of their current sales to ethanol producers in the meantime.
Friday, April 04, 2008
That's a truly mind-blowing notion. It's one thing to imagine that for a few hundred billion bucks, spread out over a decade or so, we might break our hydrocarbon addiction and embrace a cleaner world, with wind and solar energy powering an all-new fleet of electric vehicles, perhaps with plug-in hybrids as a transitional technology. Mr. McKibben suggests that what is needed is orders of magnitude bigger than that, and frankly, given the scale of a global fossil fuel economy that delivers 14 times as much energy as all the hydro-electric dams in the world--our oldest and still largest renewable energy technology--that sounds realistic. Nor is he alone in reaching this conclusion. Dr. Joseph Romm, a former DOE official and prominent environmental blogger, has also suggested the need for a World War II-sized effort, involving the construction of up to a million wind turbines globally.
I recently heard a comparison between the number of wind turbines necessary to power a new generation of US vehicles and the number of aircraft the US built from 1941-1945, which amounted to 275,000 fighters, bombers and transports. Now, I actually think that this could be done, and under the more pessimistic scenarios of climate change it might just be what is required. However, I do not see anything approaching sufficient motivation or the sense of urgency necessary to transform our economy to such a degree. Consider that in order to build all those airplanes and the other means of defeating Germany and Japan--with more than a little help from the USSR and the British Empire--we turned over a third of the economy to the war effort, with the federal government's share of GDP exceeding 40% from 1943-45--about twice the current level. Whole sectors of the economy ground to a halt, including the production of civilian automobiles. And that was at a time when manufacturing accounted for about twice as large a share of GDP as it does today, albeit with much lower productivity.
In 2004, energy expenditures accounted for 7.4% of GDP. With higher prices, it's probably closer to 10% today. Just our net imports of crude oil and petroleum products amount to 3% of GDP, at today's prices, compared to about 1.5% in 2004. But there's a real question about how much of our total economy we can devote to energy production, without crowding out the parts that turn energy into higher value outputs of goods and services. How much investment can we divert to creating a green energy economy, while maintaining large parts of the hydrocarbon economy during a transition that could last a decade or more? And the starting point for this effort would be an economy that is already running enormous fiscal and trade deficits, and facing the dramatic and entirely predictable expansion of government obligations to an aging population.
At the peak of the Apollo Program, NASA's budget consumed 5% of the federal government's expenditures, putting it somewhere around 1% of GDP. Devoting a similar share to new energy today would come to $150 billion per year, 30 times larger than the Department of Energy's 2008 budget. Ramping that up to World War II scale would put it in the vicinity of several trillion dollars per year. That is a long way, indeed, from the view of the UK government's Stern Report that addressing climate change would require around 1% of global GDP. So far, most of the campaign rhetoric about expanded energy and climate programs, as ambitious as it might be, falls well short of the relative commitment we made to landing on the moon, and even that will face opposition. While I understand the arguments of those suggesting the need for a de facto wartime mobilization to combat climate change, there is simply no way to ask the American people to undertake something of that magnitude, when we are still struggling to pay for the extension of the renewable energy tax credit, and before we have even taken our first steps on an emissions cap & trade.
Thursday, April 03, 2008
Consider the available options for reducing fuel prices. Contrary to Congressman Larson's assertion, based on complaints from the Connecticut Independent Petroleum Association, that supply and demand is broken, those forces are precisely what determine the street price of gas and diesel. When marketers see their sales spiking and inventories drawing down, they raise prices, and when sales slow and inventories rise, they lower them. Any dealer that is priced too far above his local competitors will see throughput fall, and anyone who prices too low will run out. As I used to remind our marketing managers when I traded gasoline for Texaco's West Coast operations in the 1980s, if you're going to run out, you might as well run out at a high price. Increasing supply seems to be the quickest way to force prices down, since the whole system responds to changes in inventory that result from shifts in supply and demand--the latter being harder to influence directly.
How could we increase supply? Well, Congress was suggesting more renewable fuels. In fact, the 2007 Energy Bill increased the annual Renewable Fuel Standard target for 2008 from 5.4 billion gallons to 9 billion gallons. That compares to 6.8 billion gallons of ethanol actually blended into gasoline in 2007. Even if enough new ethanol plants start up this year to supply the additional 2.2 billion gallons required, the logistics of getting it to blending terminals will be challenging. And while ethanol is cheaper than gasoline today, offering the potential of some price relief, it is not clear that will remain the case. Higher demand for corn pushes up the cost of ethanol's inputs, against a crop expected to be smaller than last year's. That will either squeeze output or raise ethanol prices.
Nor would granting the industry's request for access to more offshore tracts help this year. There's much to be said for the argument that Chevron's Vice Chairman made to the Select Committee on Energy Independence and Global Warming, that it's hard to convince foreign countries to give companies access to their resources, when our own government won't do the same. However, the interval from leasing to first production is at least six or seven years, and probably longer. So when the industry execs were asking for access, it was for the supply we'll need in the 2015-2030 time frame, not 2008 or 2009. Expanding refinery capacity might bring relief sooner, but most of the current spike in gasoline prices is attributable to higher crude oil prices, not unusually high refining margins. And in any case, of the refinery expansions alluded to on Tuesday, such as at Port Arthur, TX , few of them will come on line this year.
As for reducing demand by means of increased fuel economy, that won't manifest quickly, either. The 2007 Energy Bill set a target for increasing the fuel economy of new cars to 35 miles per gallon by 2020, but with the economy slowing and new car sales down significantly from last year, it will take longer than expected to turn over the existing fleet. If every new vehicle sold this year were a hybrid, it would raise the fuel economy of our 230 million cars and light trucks by up to 4%. But despite their rapid growth, hybrids made up only about 2% of the US car market in 2007. And while SUV sales are down--often displaced by "crossovers" that are only marginally thriftier--and small car sales up, the resulting net reduction in fuel consumption could be lost in the rounding, this year.
The only lever left for policy makers to influence current fuel prices was only hinted at in Tuesday's hearing, for good reason. One of the committee members pointed out that federal and state taxes account for 13% of today's gas price at the pump. Those taxes range from $0.26 per gallon in Alaska to more than $0.64 in California, but the one constant is the $0.184/gal. federal gasoline tax. Congress could cut that tax or eliminate it--with serious consequences for the federal highway budget--but the resulting relief would be short-lived. Because it would tend to increase demand without affecting supply, a temporary reduction in the gas tax would eventually be overwhelmed by the rebound of total fuel prices, in order to balance supply and demand. Consumers would see a few months of relief, but the Treasury would be out several billion dollars without achieving any lasting benefit.
Unfortunately, unless I've missed some non-obvious factor, that leaves government and industry with no quick way to alleviate the fuel price increases that have already swamped last year's highs, well before their typical seasonal peak around Memorial Day. That leaves only one party to this situation with the power to change that balance: consumers. If we all drove just 12 miles less per week, fuel demand would fall by 5%, the equivalent of almost half a million barrels per day, or all the ethanol produced last year. The impact of that on gas prices would be much more dramatic than waiting for someone else to fix the problem.
Wednesday, April 02, 2008
In his remarks, Rep. Markey (D-MA) issued a challenge to oil companies to invest 10% of their profits in renewable energy, with the veiled threat that if they didn't, then losing $18 billion per year in tax benefits might not be the worst outcome they face. Absent from this exhortation, however, was any recognition that some forms of renewable energy are not as beneficial as others, either in terms of reducing greenhouse gas emissions or in making a substantially positive net contribution to the country's energy balance. The committee seemed to be saying that biofuels are the obvious answer, and that any oil company not investing large sums in them is cheating consumers. While that might provide useful soundbites for some House Members' reelection campaigns this fall, this line of argument has largely been superseded by events.
Although the net impact of renewable energy remains modest, compared to the energy we derive from fossil fuels, the recent dramatic growth of biofuels has positioned them as a key element of current and future liquid fuel volumes, which no industry supply and demand forecast can afford to ignore. With one exception, the companies whose executives testified yesterday are already significant participants in this sector, with investments in biofuel production, next-generation biofuel R&D, and, as a result of fuel specifications and renewable fuel mandates, as some of the largest blenders of biofuels in the world. It remains to be seen, however, whether any of these companies will ultimately come out on top in the renewable energy marketplace, which is dominated by a host of new entrants. This is a classic case of the Innovator's Dilemma, with the major oil companies' renewable energy businesses having to compete for financial and human resources and management attention with the giant upstream and refining segments that are still the engines of oil company economic value, and will be for years to come.
When asked their highest priorities for addressing today's high energy prices and our reliance on imported oil--a situation that Chevron's Vice Chairman, Peter Robertson, characterized as "unsustainable"--all of the execs cited the urgent need for gaining access to oil and gas resources that the Congress and various states have placed off limits. (Disclosure: I own Chevron stock.) The execs stopped just short of saying that, if the Congress is serious about bringing down energy prices, it could have the largest impact by opening up the 85% of the outer continental shelf waters that are presently off-limits for drilling, rather than hammering on oil companies to invest in renewables. That is certainly born out by the size of the potential offshore opportunity, which could easily add another 1-2 million barrels per day to slipping US oil production, and by the enormous differences in physical and financial scale between conventional and renewable energy projects. ExxonMobil isn't wrong to suggest it can make more impact by sticking to its knitting in this regard, though I continue to believe they will eventually regret not taking a position in renewables now--a defensible strategic choice that has been a PR disaster for them.
The financial realities of this were explained in greater detail by Mr. Robertson in a blogger teleconference (podcast and transcript available shortly) following the hearing, arranged by API, in which he cited 40 global oil and gas projects in which Chevron is engaged globally, each greater than a billion dollars, Chevron's share, and each expected to provide substantial, profitable production. At the current scale of renewables, there are still relatively few billion-dollar projects of the kind that companies of this size must pursue, in order to have a measurable impact on their results and on shareholder value. It is still uncertain whether the billions that companies such as Shell, Chevron, ConocoPhillips and BP are investing in renewables will yield results on that scale.
I also noticed a surprising omission in yesterday's proceedings. While both the committee and the witnesses mentioned the enormous potential of Canada's oil sands for reducing US dependence on unstable overseas suppliers, the prospect that imports of oil sands syncrude might be blocked by US environmental regulations was only referenced obliquely by Mr. Simon of ExxonMobil. As I noted recently, this issue could have severe supply repercussions in the Midwest, where much of the Canadian oil we import is consumed, as well as for the overall US oil import mix. I'd call that a key missed opportunity on the part of the companies.
So with the committee telling the oil companies to help consumers by investing in renewables, and the oil execs asking Congress to help consumers by lifting restrictions on off-limits oil and gas resources, what was constructive? Well, there was a very encouraging discussion about energy efficiency and its vital contribution to reducing emissions and saving money. This is surely common ground on which the industry and government could cooperate more. The companies also heard some sage advice from Rep. Candice Miller (R-MI) that, regardless of the economic justification of their profits and prices, they face significant consumer and regulatory backlash if they aren't seen to "do the right thing with these profits." I think they ignore that at their peril and ours, because the likely regulatory response would harm the industry and be counterproductive for the entire country. Perhaps most revealingly, though, and in sharp contrast to a similar hearing involving the CEOs of these companies several years ago--and to an entirely out-of-context clip from yesterday's event that aired on last night's NBC Evening News--there was little disagreement about the fundamental drivers of high oil prices, and the degree to which the US is integrated into global energy markets. In that respect, at least, our national conversation about energy has progressed in useful ways since 2005.