Election 2012: Romney on Energy

After last week's review of President Obama's energy record and campaign materials on energy, Governor Romney's energy plans present a sharp contrast. They are based on a fundamentally different view of energy and the economy, relying on markets to allocate capital to the most productive opportunities, rather than on government to guide a mix of public and private investments along specific paths towards designated ends. They also emphasize technologies that are already deployed at scale today, not those still under development or striving to attain scale. Implicitly, the Romney plan prioritizes supplying the energy for a robust economic recovery over programs designed to address long-term environmental challenges like climate change. These positions present voters with a serious and consequential choice on November 6th.

The Romney campaign's website on energy arrays the candidate's ideas mainly in words, rather than with the kind of images and interactive features that dominate the Obama campaign's sites. Energy is the first plank of Governor Romney's five-point "Plan for a Stronger Middle Class", though it requires a little work to explore the details of his energy program. A list of bullet points  is backed up by a lengthy policy paper with numerous references to external sources, but you have to look for it.

The Romney energy plan focuses mainly on oil, gas, coal and nuclear energy, which together meet 91% of current US primary energy demand and which the Department of Energy projects will still provide nearly 90% in 2020 under the policies in place today. You won't find much on his campaign's website about the new renewables that generated electricity equivalent to 2% of our energy use last year, beyond a critique of the administration's investment in Solyndra and a commitment to R&D on new energy technologies.

Among the details of his plan are support for expanded offshore drilling, including areas such as offshore Virginia that were originally in the Obama administration's early-2010 offshore development blueprint, along with a comprehensive assessment of US resources using current technology, rather than further extrapolations based on 1980s technology. Governor Romney proposes expanding energy cooperation with both Canada and Mexico and would approve the entire Keystone XL pipeline. His goal of attaining North American energy independence is aggressive, yet recent analysis by Citigroup puts it within the realm of possibility. It appears to be based on an assessment by Wood Mackenzie, a top-notch energy consultancy, indicating that US oil and natural gas liquids output could expand by 7.6 million barrels per day, with 6.7 million of that coming from federal lands and waters currently off-limits to development. That compares to US net petroleum imports of 8.5 million barrels per day in 2011.

Another aspect of the plan aimed at streamlining the permitting of energy projects could be just as useful for utility-scale renewable energy projects as for oil and gas exploration and production. Regulatory and permitting delays are among the key reasons it takes longer and costs more to develop crucial energy and infrastructure projects here than in many of the countries against which our competitive standing has been slipping. Governor Romney also proposes giving states greater control of permitting on their non-park federal lands. That could substantially increase energy access and output, especially in the west, where the federal government owns over 280 hundred million acres, or 37% of those 11 states, net of tribal lands.

There are also some missing elements. I would have liked to see more about how renewables fit into Governor Romney's vision. He apparently supports the Renewable Fuels Standard but is silent about the increasingly urgent need to reform it. He is on record against the extension of the wind Production Tax Credit (PTC), a 20-year old subsidy roughly equivalent to the current price of natural gas, yet misses the opportunity to explain how all types of energy would be treated under his proposal to reduce corporate income tax rates while broadening the tax base--policy-speak for closing loopholes and eliminating incentives. In last night's debate he said, referring to the $2.8 billion in annual tax incentives for oil and gas identified by the Department of Energy, "... if we get that tax rate from 35 percent down to 25 percent, why that $2.8 billion is on the table. Of course it's on the table. That's probably not going to survive (if) you get that rate down to 25 percent." I'd also like to hear more about how Governor Romney would address greenhouse gas emissions once the economy returns to stronger growth.

Superficially, much of the Romney energy agenda evokes a return to the pre-2008 status quo: heavy on oil, gas and coal, light on renewables, and largely ignoring climate change. I see it from a different perspective: When Barack Obama began running for President in 2007, the US was considered by many to be tapped out on conventional energy, with domestic oil and natural gas production exhibiting signs of deep and permanent decline. In that context it made sense to look beyond those resources to the potential of renewable energy and vehicle electrification, even if the transition involved would be lengthy. That approach also appeared synergistic with reducing greenhouse gas emissions, and a strategy was born. In the meantime, however, it turned out that US oil and gas were far from exhausted, and the most productive new energy technology of this decade wasn't wind, solar or biofuels, but the combination of hydraulic fracturing ("fracking") and horizontal drilling that has unlocked hundreds of trillions of cubic feet of shale gas and tens of billions of barrels of shale oil or "tight oil" resources. Since 2008 the expansion of shale gas drilling has added as much new US energy production as over 250,000 MW of wind turbines or solar panels--8x the wind and solar power added in the same interval. To the surprise of many, the big global energy opportunity of the 20-teens is US hydrocarbons. The Romney plan reflects the unexpected energy transformation we're experiencing.

As in 2008, this blog isn't in the business of endorsing candidates. Energy remains an issue that, like the Cold War, demands bi-partisan cooperation and some level of consistency from one administration or Congress to the next. However, that doesn't prevent me from observing that the energy agendas of the two campaigns are not equally well-suited for a period of serious US fiscal constraints and shrinking federal discretionary expenditures, in which our energy security and economic growth will still depend largely on fossil fuels. In that context, it's highly relevant that the "all of the above" credentials of one candidate depend on oil and gas outcomes that his policies did little to support. Of course, energy isn't the only issue that matters, but then you wouldn't be reading this if you didn't think it was important.

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Candidates & Energy 2012: Obama

It's curious that energy hasn't been as big an issue in this year's presidential campaign as it was in 2008, the year of "Drill, baby, drill."  The price of unleaded regular gasoline has averaged roughly a dime per gallon higher through September than either last year or the same period in 2008, when prices peaked at $4.11 per gallon in July.  Gas prices are higher this year because global oil prices are also higher, with UK Brent crude averaging $15 per barrel over its 2008 full-year average, though without a similar spike.  One explanation for the reduced focus on energy is that President Obama co-opted his opponents' "all of the above" prescription, while indicators such as US crude oil production and natural gas output and prices have been moving in favorable directions.  The Obama campaign and key administration officials routinely draw a strong causal connection between those two facts, forming the basis of their campaign on energy.  But is that claim true?  Like the Washington Post fact checker's assessment of another frequent presidential assertion about energy, a finding of "true but false" seems appropriate.

Although I had intended to provide a side-by-side comparison of President Obama's and Governor Romney's energy agendas, it quickly became obvious that that was impractical, due to length and complexity.  I'll take a look at the challenger's ideas next week.  Since any re-election bid is fundamentally a referendum on the incumbent, it made sense to start with the record of an administration that came into office with an unusually clear and clearly articulated vision on energy, experienced some notable victories and defeats along the way, and ended up embracing a pair of big, emerging trends that it had done virtually nothing to foster. 

That is readily apparent when it comes to oil production, which must be a core element of any "all of the above" approach, since that "all" implicitly includes fossil fuels along with renewables and efficiency.  Go to the Obama campaign web page on energy and you'll see this chart:

It's a rescaled version of the chart below, which appears on the WhiteHouse.gov site on gas prices:

Aside from the fact that changing the axis scale makes the trend look much more dramatic, what's entirely missing from both these charts and the websites where they appear is any cogent explanation of why oil production is rising.  That requires some context about the industry and oil markets that I've overlaid in the following graphs:

Most oil projects big enough to matter aren't accomplished overnight. The process typically involves acquiring onshore or offshore leases, obtaining the necessary permits, conducting exploration activities that only proceed to the next step based on success, planning the required production wells and processing facilities, competing for internal funding against other company projects, obtaining additional permits, constructing facilities and drilling the production wells. Every step takes time.  Depending on the complexity of the project, the overall timeline can span from three to seven years, and that's if no one sues to block the project.  To see why oil production has been rising since 2009, we need to ask what was happening in 2003-6.  The answer is that after many years of being stuck in a range of $20-30 per barrel--with an excursion down to single digits in the late 1990s--oil prices tripled during that period, mainly due to the combination of global economic growth, especially in Asia, and the lagged effect on oil project investments from that late-'90s price crash.  In other words, production went up mainly because five or six years earlier the financial rewards for drilling suddenly got much bigger.

So at a minimum it's a stretch--mere spin--to claim credit for higher production that is attributable to events and perhaps policies on your predecessor's watch.  However, the picture looks worse when we factor in the policies and attitudes that went into effect when this administration took office in early 2009.  Recall that one of the first energy decisions of the new administration was Interior Secretary Salazar's cancellation of previously awarded oil leases in Utah.  Later that year a senior Treasury official--currently chairman of the President's Council of Economic Advisers--testified before Congress that US policies were promoting the "overproduction of US oil and gas", just as the now-touted production surge was starting.  For at least its first several years, the rhetoric and actions of the Obama White House were generally consistent with that view and with Mr. Obama's portrayal of oil and gas as "yesterday's energy" in his 2011 State of the Union address.  The brief offshore drilling opening signaled in spring 2010 was quickly retracted following the Deepwater Horizon accident, with the imposition of a six-month offshore drilling moratorium and subsequent "permitorium". Those responses--justified or not--resulted in Gulf of Mexico production falling by 22% since mid-2010, a decline that has been masked by the tremendous success of "tight oil" exploration and production in Texas and North Dakota. (The time lag for the moratorium's effects was negligible, because the deepwater projects that were halted had already been planned and permitted.)

In fact, the President's adoption of "all of the above" is fairly recent, making headlines following his 2012 State of the Union. It represents quite an evolution from Senator Obama's 2008 emphasis on renewable energy and climate change mitigation. President Obama certainly pursued those agendas with vigor, incorporating billions of dollars of federal grants and loan guarantees for renewables in the 2009 stimulus, backing the Waxman-Markey cap-and-trade bill, and at both the Copenhagen and Cancun UN climate conferences committing the US to significant greenhouse gas reduction targets and further negotiations. 

It hasn't all worked out as planned, though.  Notwithstanding the high-profile bankruptcies of Solyndra--a colossal failure of due diligence by the administration--and other loan guarantee and grant beneficiaries, the output of wind, solar and other non-hydro renewable energy generation has indeed grown by 55% since 2008, increasing from 3.1% to 4.7% of total US electricity generation, equivalent to 1.9% of total energy consumption.  Yet sadly the wind and solar manufacturing sectors that were to have produced so many "green jobs" are caught up in parallel waves of excess global production capacity that could take years--or wrenching consolidation--to work off.  The overcapacity that has blighted the prospects of many of these companies is largely attributable to the generous incentives provided by the US and other governments from Europe to Asia.  Direct wind and solar jobs accounted for just 54,000 of the US "clean economy jobs" tallied by Brookings and Battelle in their study last year, and they look no more secure than non-green jobs.

Climate policy is another area featuring a big disconnect between effort and results. With control of both Houses of Congress, the President backed a climate bill that exhibited all the worst tendencies of that body: 1,092 pages of bloated regulations and carve-outs for favored constituencies.  Even to someone who had supported the idea of cap and trade for a decade, it was a dog's breakfast, configured mainly as a production-inhibiting tax on the US petroleum sector.  Waxman-Markey failed to pass the Senate, and a more bi-partisan bill died in the aftermath of Deepwater Horizon and the recession. Whatever one's views on the science of climate change, costly climate legislation looked like a bad bet in a weak economy.  Actual emissions have fallen, however, as a result not of policy but of another trend that wasn't on the administration's radar screen until it grew too large to ignore: shale gas.  Emissions are at a 20-year low, mainly due to fuel switching from coal to cheap natural gas in the utility sector.

Another key trend cited as evidence of the effectiveness of the administration's energy policies is the reduction of oil imports that has occurred since 2008.  Yet like the facts on oil production, the causes are only tenuously connected to those policies.  From 2008-11, US net petroleum imports fell by 2.6 million bbl/day (MBD), including refined products.  That goes a long way toward achieving then-candidate Obama's goal of reducing imports by an amount equivalent to what the US imported from the Middle East and Venezuela.  However, the biggest contributor to this reduction was the 1.1 MBD increase in total US petroleum production (including natural gas liquids), followed by a 0.6 MBD drop in demand that had more to do with reduced driving and the weak economy than the early gains from tougher fuel economy rules. Increasing biofuel production associated with the 2007 Renewable Fuel Standard contributed another 0.3 MBD, although that policy now stands in urgent need of reform.

I have watched many elections in my life, and I can't honestly say I'm surprised to see an administration running on something other than its actual energy record, which in this case includes positives such as funding ARPA-E's potentially transformational energy R&D and having enough sense to keep largely out of the way of the shale gas revolution--at least for now. Yet having focused 90% of its efforts on a set of technologies that look important for the future but will still meet less than 10% of our energy needs for some time to come, they have now hitched their electoral wagon to an oil production surge that they didn't help and partly hindered.  I can only imagine that this would be deeply disappointing to those who supported Mr. Obama in 2008 because of his vision for alternative energy and the environment.  Nor does it provide much comfort to those who found large portions of that agenda ill-considered or premature. The President's 11th-hour conversion to "all of the above" creates great uncertainty about the course he would pursue with regard to energy for the next four years, if reelected. 

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Why Are Gasoline Prices So High in February?

US gasoline prices are setting records for this time of the year, with the current price apparently the highest ever for February, at least in nominal dollars. In fact, the monthly average US retail price for unleaded regular has set new records every month since last October. That isn't quite as dramatic as it might seem, because based on the Department of Energy's data, the previous records for those months were set just a year earlier. Yet it's still a significant drag on the economy--an anti-stimulus, as I've noted previously. Unfortunately, some of the explanations I've seen for these price levels, including the ones offered in last night's CBS Evening News, focus too much on minor factors such as refinery maintenance and commodity speculation, while ignoring the most basic influence: the price of oil. That's understandable if they're watching the wrong oil price.

If you've been reading this blog for a while, you know why the most-watched oil price in America, the one for West Texas Intermediate crude (WTI), is no longer representative of the broader US oil market, at least for now. The best domestic grade to follow at the moment is probably Louisiana Light Sweet (LLS), which is of similar quality to WTI but not subject to the persistent transportation bottleneck at Cushing, OK. It tracks closely to UK Brent crude, which has largely taken over the role of global oil price indicator. The "spot" price of LLS was $119 per barrel today, accounting for 94% of the price of prompt gasoline futures on the New York Mercantile Exchange (NYMEX) today. And the $16/bbl increase in LLS since February 9, 2011 explains nearly 80% of the increase in the wholesale gasoline price over that interval. So while refinery outages might be having some impact, particularly in the local and regional markets served by the affected facilities, they are not the main show, nor is speculation in gasoline futures, the effect of which beyond the New York area covered by the NYMEX contract should be rather attenuated.

So with gas prices this high, this early in the year, how high might they be when the summer driving season arrives? That also comes down to crude oil, prompting questions about why oil prices are so high today, despite relatively weak demand. Many analysts attribute oil's strength to worries about Iran's threat to close the Strait of Hormuz as the sanctions noose tightens, along with rumors that Israel may be preparing to strike Iran's nuclear sites on its own this spring. But as with any such risks, they will either manifest or they won't, and the more time that goes by without these feared events occurring, the less influence they are likely to have in propping up oil markets, absent a surge in underlying demand due to a strengthening global economy. If none of that takes place, then oil prices could ease, resulting in summer gas prices not much worse than what we see today. However, I'd be wary of reversing that logic: Keeping gas prices low is not a sufficient reason to back away from addressing the risks posed by what the International Atomic Energy Agency refers to as the "military dimensions" of Iran's nuclear program.

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Why Haven't Gas Prices Fallen More?

With the US economy stuck in the doldrums, weakening the demand for oil and its products, and with the fall of at least portions of Tripoli foreshadowing the eventual return of Libyan oil exports to the market, it must seem puzzling that US gasoline prices haven't dropped farther in the last few weeks. As of Monday, the national average price for unleaded regular stood at $3.58 per gallon, only 3% lower than a month ago, when crude oil was just shy of $100 per barrel, compared to around $84 today. On Monday's evening news, CBS ran a segment attempting to explain this apparent disconnect. Unfortunately, they over-simplified the main explanation with a graphic showing cheaper domestic crude oil mixing with higher-priced imported oil. The "A" answer to this question is simpler but not well-understood, even though its elements have been fairly widely reported: Americans are simply looking at the wrong crude oil price, out of long habit. When you compare current gasoline prices and more representative crude oil prices, there isn't much of a disconnect about which to grumble.



The source of this confusion is the price of West Texas Intermediate crude oil (WTI), which for three decades has been the most watched and widely traded oil price in the world, and the basis of what most people mean when they talk about the price of "oil." In fact, there are numerous distinct grades of oil, each with its own price reflecting quality, location and availability. However, until recently most of these prices were based on the price of WTI, plus or minus a relatively narrow band of premiums or discounts, so using WTI as a barometer of all oil prices didn't cause much confusion or inaccuracy. The emergence of a pronounced and lengthy supply bottleneck at the Cushing, OK delivery location for the WTI futures contract has exploded this convenient set of relationships and assumptions.



Because more oil has been going into tankage at Cushing than was leaving those tanks over the last year or so, the price of WTI--itself a category, rather than a single stream of oil--has become massively depressed relative other types of crude oil, not just imported oil but also oil in other locations in the US that aren't affected by the bottleneck. Consider some important examples. While oil produced in Kansas, New Mexico and Oklahoma is all cheaper due to the Cushing effect, Louisiana Light Sweet, which historically traded within a dollar of WTI, is now worth nearly $20/bbl more, putting it much closer to the price of UK Brent crude--the best current gauge of global oil prices--than to WTI. Meanwhile, Bloomberg reports Alaskan North Slope crude (ANS) for delivery on the West Coast at nearly $107/bbl, or $24 over WTI. That's surprising, considering that ANS is heavier and higher in sulfur than WTI, and thus requires more processing. Just as remarkably, California heavy crude at Midway-Sunset is quoted at more than $10/bbl above WTI, when based on history and quality I would expect to see a discount of at least that magnitude. In other words, for now at least, the price of WTI is simply no longer representative of the crude that many US refineries are processing, from either foreign or domestic sources.



When you compare the wholesale price of gasoline from US refineries near the East, West and Gulf coasts to the cost of their crude inputs at around $100 or more, the difference of $15-17/bbl isn't historically unusual. Meanwhile, refineries in the middle of the country have recently been experiencing much stronger margins. This disparity is evident in the second quarter earnings reported by various US refining companies. East coast refiner Sunoco, which hasn't benefited much from cheap WTI, reported a net loss for the quarter, while Valero, with a bigger and more geographically dispersed refining system that includes facilities processing large quantities of WTI-related crude, saw refining segment earnings increase by 39% compared to the second quarter of 2010. The Cushing effect was even more pronounced for the recently merged HollyFrontier Corp., which apparently runs little crude that isn't priced near WTI and saw second-quarter net income almost triple versus 2Q2010. Even after that extra profit margin, gas prices in Tulsa, OK are currently as low as $3.30/gal., or about 15 cents per gallon less than the national average after adjusting for differences in state gas taxes.



Gasoline prices are determined by more than just crude oil prices, though in the long run the two must move together, because the latter represents the largest component of the cost of the former. At least until the bottleneck in Cushing is resolved by new pipeline capacity to the Gulf Coast, one option for which was just canceled, we will need to look beyond our old reliable WTI price indicator in order to compare gasoline and crude prices on a representative basis. I've been paying a lot more attention to the Brent market, and the Wall St. Journal still publishes daily prices for Louisiana Light Sweet and ANS. When and if those indices drop significantly, then it will be time to start looking for a commensurate drop in retail gasoline prices at the pump.

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How Big Is the Leak?

The question of the week seems to be just how much oil is leaking from the damaged well in the Gulf of Mexico. I have steered away from the controversy over these dueling estimates until now, because I didn't think I had anything relevant to add. But this mystery has intrigued me for days, particularly as the gap between the official estimate and those from outside scientists grew to alarming--and suspicion-provoking--proportions. How can there be such a wide disparity on something that seems like it should be so simple, and who is right, or a least closer to right? Two numbers in a report yesterday on BP's efforts to siphon off part of the flow provided a key data point for interpreting some of the higher estimates.

The most-frequently cited external estimate I've seen comes from Steven Werely, Ph.D., an Associate Professor of Mechanical Engineering at Purdue University. Dr. Werely is an expert in fluid mechanics--one of the tougher disciplines I encountered in my chemical engineering curriculum, long ago. He has applied a technique called "particle image velocimetry" to the video of the oil leaking from the broken well and derived a flow estimate of 95,000 barrels per day, plus or minus 20%. He has shared this result in front of Congress and with a number of news outlets. It's a frightening number, and he presents it very credibly, though when I saw him interviewed last week on BBC America World News, he was careful to point out that he didn't have an oil and gas background, and thus lacked some context for framing his estimates.

My reaction to this figure was that it was so far beyond the range of my knowledge of what oil wells typically produce that it seemed incredible. For example, Chevron's Tahiti deepwater platform in the Gulf produces a total of 125,000 bbl/day of oil from six wells with none of the constrictions, obstacles and other problems that BP's Macondo well has. It also occurred to me that Dr. Werely's technique really measures what engineers would call "space velocity", or the total volume of fluid moving past a reference point, whatever its composition. If the fluid consisted entirely of oil, then the space velocity and oil flow rate would be identical. However, we know that at least some of that fluid is natural gas, affecting its density. But until I saw the latest report on BP's efforts to collect some of the flow with the "straw" they inserted into the end of the riser, I had no way to gauge that--nor perhaps did Dr. Werely.

I realized that if 5,000 bbl/day of oil are now being collected at the surface along with 15 million cubic feet per day of natural gas being flared, then roughly that same ratio of gas to oil should apply to the fluid we see coming out of the well, adjusted for the effects of depth. Under 5,000 feet of seawater with a pressure gradient of 0.445 psi/foot, that gas will behave differently and take up a much smaller, but still not insignificant volume. At this point in my logic some dormant engineering brain cells sprang to life and I started figuring out the volume that the gas being measured at the drill-ship, at atmospheric pressure and temperature, would occupy at 2,225 psi and a degree or two above freezing, using standard pressure-volume-temperature relationships. My back-of-the-envelope calculation indicates that this amount of natural gas would equate to 16,600 barrels per day (of compressed gas , not oil) at the depth of the broken well and riser: in other words, a higher apparent volume than the oil that accompanied it to the surface through BP's "straw".

While I made several simplifying assumptions along the way to that result, it at least suggests the possibility that the majority--perhaps over 75%--of the visible flow billowing out of that broken pipe, and upon which scientists are basing their estimates, might consist of gas dissolved in the crude oil and compressed gas that has come out of solution but is mixed into the oil by the turbulence of the flow. I can't tell to what extent Dr. Werely has already factored this in, though his comments in this article in Science News seem to suggest that he regards it as a big uncertainty with the potential to scale down his estimate. If so, his mean 95,000 bbl/day figure might consist of something less than 25,000 bbl/day of actual crude oil, plus a much larger quantity of natural gas that would mostly escape into the atmosphere and couldn't foul any beaches. That's still a lot more oil than BP and the federal government had been quoting, but it's not orders of magnitude higher.

So where does this leave us? Apparently, BP is now conceding that the leak must be larger than their 5,000 bbl/day estimate, because they can measure that much oil going into their drill-ship on the surface, and there's still more leaking. At the same time the gas/oil adjustment could bring the high-end estimates from experts like Dr. Werely into the same general ballpark as the flow rates that other wells are known to produce, albeit under more controlled circumstances. That might give us a much better figure from which to calculate how much oil could eventually reach the shore, after its lighter components, such as propane, butane, and naphtha, have evaporated in the warm Gulf Coast conditions.

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The Context for Offshore Drilling Policy

Yesterday's posting considered possible scenarios for the oil spill emanating from the leaking well in the Gulf of Mexico and explored a few of the implications for US policy towards further offshore drilling. Debate on this topic has already begun, and I expect it to heat up in the weeks ahead as the Congress and administration decide whether to take up energy legislation this year, and as the spill and its direct consequences spread. In order for this debate to be productive, it requires a context, preferably one that encompasses more than the latest images from the Gulf Coast. The environmental consequences of this drilling accident can't be ignored, and neither should the economic and energy security consequences of overreacting to it. My main worry in this regard is that, although we've had spills like this before, we've never had a spill like this in conjunction with politics like today's.

Understanding how offshore drilling fits into the US energy economy seems fairly daunting, but a few key insights can clarify why it has become an indispensable part of our energy supply over the last couple of decades, and why it will remain crucially important, even as we make the transition to a more energy-efficient economy, relying on lower-emitting, more-sustainable energy sources. Total primary energy supply and demand is a useful starting point. In 2008, the latest year for which the Energy Information Agency (EIA) of the US Department of Energy has compiled figures, oil covered 37% of our primary energy demand. On this basis, domestic offshore oil production accounted for about 1/10th of our total domestic and imported oil supply, or just under 4% of all the energy we used. If that doesn't sound like very much, consider that it exceeded the entire contribution of wind, solar, geothermal and hydroelectric power that year. Primary energy isn't the most useful comparison, however, because very little oil is used to generate electricity, and very little electricity is used in transportation. Petroleum and its products hold a unique position in our economy, providing most of the energy for transportation and numerous chemical building blocks for industry.

For decades US oil production and consumption were trending in opposite directions, opening a huge gap that had to be filled by increasing quantities of imported oil and, more recently, by the small but growing contribution of biofuels. Even with US oil demand reduced by 9% due mainly to the recession, net crude oil imports last year still averaged 9 million barrels per day (bpd), or 1.7 times as much oil as we produced here (excluding natural gas liquids.) One of the main reasons those imports weren't higher was that after years of decline, domestic oil production has staged a modest recovery. As the chart below depicts, those gains are entirely attributable to the expanding production of oil from the federal waters of the Outer Continental Shelf (OCS)--the result of deepwater exploration such as that which Deepwater Horizon was engaged in when it exploded and sank.


Another key factor in the context of offshore drilling policy is oilfield decline. When you stop drilling new oil wells, production begins to fall as existing wells and reservoirs deplete. As a result, calling a halt to offshore drilling wouldn't imply a standstill in production; it would guarantee a significant decline in output from year to year. My estimate of the magnitude of what's at stake comes from comparing the most recent production forecast from the EIA with the application of realistic decline rates to current offshore production. As shown below, the EIA's 2010 Annual Energy Outlook (Early Release) projected domestic oil production rising back above the 6 million bpd level by 2019, mainly on the strength of drilling success in the deepwater Gulf of Mexico. Without continued drilling offshore, US oil output could be 1.5 million bpd lower than expected by 2020--a very serious shortfall. (That's the gold wedge shown below.) And that would be the case even if onshore production remained stable over that period, which would be unprecedented since the mid-1980s.

The impact of such a shortfall would go beyond its direct economic value of around $55 billion per year at today's futures market price for 2018. We must also consider what would replace it. Now, by 2020 there could be enough electric vehicles on the road to make a noticeable dent in our oil consumption, although most EV advocates expect the electricity they would consume to back out imported oil and petroleum products, rather than standing in for missing US production. In any case, the majority of cars sold in this country between now and then will burn gasoline and other liquid fuels, so the most practical alternative to offshore oil in this timeframe would be biofuels. Unfortunately, as the chart below shows, current US ethanol output equates to just a fraction of our offshore oil production, after adjusting for ethanol's lower energy content. Corn ethanol production is approaching its mandated level of 15 billion gallons per year, equivalent to 640,000 bpd of gasoline. (It's also approaching the 10% blending limit in gasoline.) Even if the nascent technology for cellulosic ethanol and other advanced biofuels can deliver on the aggressive targets set in the national Renewable Fuel Standard, this would still contribute less energy than the 1.5 million bpd that's at stake offshore. And as with EVs, a barrel of biofuel filling in for lost offshore domestic oil can't be counted again to reduce imports.
As President Obama alluded to in his announcement in March concerning expanded offshore drilling--pre-Deepwater Horizon, to be sure--domestic oil production has an important role to play in any comprehensive energy policy aimed at reducing our oil imports and greenhouse gas emissions. As I've shown above, offshore oil is the key to stable, dependable US oil production. When you examine the data and realistic projections concerning the contribution of renewables and other alternative energy sources over the next decade, it becomes clear that turning our back on offshore oil production would hobble those efforts by diverting their impact. Although we do have many alternatives to offshore drilling, as critics are quick to point out--including increased fuel economy, vehicle electrification, expanded biofuels, and increased use of natural gas in vehicles and other places we now use oil--we can't employ these steps to both backstop failing domestic oil production and back out oil imports or displace coal-fired power generation. That's because the energy in the quantity of oil at stake is of about the same magnitude as the contribution of these options, at least for the next decade or so. Our policy towards offshore drilling in the aftermath of the Deepwater Horizon accident must take that reality into account.

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2009 US Petroleum Trends

The American Petroleum Institute (API) released its annual oil statistics for 2009 to the press yesterday afternoon, and I participated in their media teleconference this morning covering the results. The numbers reveal some interesting shifts, and they provide another useful barometer on the state of the US economy, for which oil is still the largest energy input by a wide margin. Total petroleum and refined products deliveries, reflecting aggregate demand, continued their downward trend last year, averaging 4% below 2008 levels, but interestingly were only down 1.8% in the fourth quarter, compared to 4Q08, with December actually showing a slight uptick vs. December '08. Here are a few of the underlying details that caught my eye, and my reactions to them:

• Gasoline bucked the overall downward trend in product demand. Despite prices that recovered steadily throughout the year from their late-2008 lows and surpassed their year-earlier levels in the fourth quarter, gasoline demand posted a 0.3% increase vs. 2008, with 4Q09 showing a 1.1% rise compared to 4Q08 and an even stronger finish in December. This is entirely consistent with the observed reversal of the decline in vehicle miles traveled, which still dominates improvements in fuel economy, despite the Cash for Clunkers uplift.
• In contrast, diesel demand remains very weak, with the low-sulfur and ultra-low-sulfur diesel deliveries that correlate with goods shipments and overall economic activity running at 7.5% below 2008, with little or no improvement in 4Q09. (Are the results of recent gains in economic activity mainly replenishing depleted inventories?)
• US refineries operated at less than 83% of their nameplate capacity for the year and fell below 80% in December. The poor margins this creates are buffeting oil company earnings but buffering consumers from the full impact of recent increases in oil prices. If utilization stays at such low levels, a major shakeout in refining could be coming, beyond the refinery closures we've already seen. This will be exacerbated by the completion of major refinery expansions on the Gulf Coast, including Marathon's Garyville, LA refinery project starting up now and the more-than-doubling of the former Texaco Port Arthur refinery, now owned by a joint venture of Shell and Saudi Refining, due within a few years.
• US imports of crude oil and petroleum products fell by over 9%, with products taking the biggest hit, proportionally, falling by half a million barrels per day. This is good news and bad news, since much of it is the result of the weaker economy.
• Happily, roughly a third of the drop in imports was attributable to higher US production of crude oil and the liquids accompanying higher natural gas output--a byproduct of the shale gas boom. As API's Chief Economist John Felmy pointed out in the call, that was partly the result of a year without major hurricanes in the Gulf of Mexico. However, it also validates the time lags involved in bringing on new production triggered by the spike in oil prices that began in 2003-4.
• The mix of our foreign oil suppliers is also shifting, with lower imports from Mexico--production there is collapsing--and Venezuela, two of the mainstays of our supplies over the last several decades. Despite this, imports from the Persian Gulf made up just 17.5% of the total through October, compared to 22.5% from Canada. And although they didn't make the top 10 list this year, imports from Brazil are coming on strong. This is a testament to that country's policies for developing its vast new resources. Look for Brazil to enter the top 10 list this year, as Mexican output continues to drop and Brazil surges.

I'm sure I missed some other nuances, and I regret not being able to provide links to the original figures, since access to the data requires a subscription. I'm sure I'll be commenting on many of these trends at greater length and referring to public data from the Energy Information Agency of the Department of Energy, as they become available.

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2009: Energy Year in Review

As I was considering this year-end summary, it struck me that 2009 seemed to span more than a single year. It began with the economy plummeting with no obvious bottom in sight and energy demand falling with it. Later, as the financial system stabilized and the psychological impact of stimulus efforts in the US, China and the EU took hold, markets began to recover and the nascent depression became a nasty recession that apparently ended in the 3rd quarter. However, in a reversal of last year's dynamic, energy was mostly driven by the economy, instead of the former driving the latter. And unlike 2008, when oil grabbed the most headlines, the big energy stories of this year concerned natural gas and renewables, along with efforts to reduce emissions of the greenhouse gases that accompany most energy use.

For oil prices, 2009 was certainly two years in one: A weak first half in which the price of West Texas Intermediate Crude averaged just under $52 per barrel, and a much more stable second half averaging around $72. Nor did prices exhibit anything like their volatility of 2008, which started in the $90s, peaked near $150, and ended in the $40s after a dip to the low $30s. By comparison, 2009 looked more like a continuation of 2006 or 2007, as if 2008 never happened, but with the primary focus inverted from concerns about supply to worries about demand. It'll be a few months before the final figures are in, but it appears that global oil demand was down by 2% vs. 2007, with demand in the US off by a whopping 10% through September.

The impact of weaker demand on the refining sector was particularly severe, compressing margins and forcing the permanent closure of at least one major US refinery. The average US gasoline price for the year was nearly $0.90 per gallon lower than in '08, saving the average driver around $35 per month. The even larger savings in the first half probably constituted the most meaningful stimulus that most consumers were seeing at that point.

If the oil news centered on weak demand and OPEC's efforts to restrain supply, for natural gas it mainly highlighted the remarkable resurgence of US gas production, thanks to the shale gas revolution. If this trend can be sustained it has significant implications for the entire economy and for the emissions we produce. It also poses a serious dilemma for environmentalists, because the shale gas bubble and its benefits for climate change would evaporate if the drilling practice called hydraulic fracturing were to be banned or severely restricted. Also at stake is the potential revival of the US petrochemical industry, which relies much more heavily than its foreign competitors on natural gas as a feedstock, instead of oil. The jobs involved might not be exactly "green", but they are certainly desirable ones, in the sense of providing above-average wages. Government regulation of gas drilling and other aspects of the energy industry will be the trend to watch next year.

Speaking of government influence, it was crucial to the survival of the renewable energy industry in 2009. Aside from the strong vote of confidence and hefty financial commitment to renewables embodied in the stimulus bill, government grants to renewable energy developers stood in for the frozen "tax equity" market on which developers had previously relied to help finance wind farms and other facilities. US wind power capacity is on track to grow by around 28% this year to roughly 33,000 MW, though even at this impressive level it will still contribute just 2% of net electricity generation, for which the bigger story this year was the more than 10% drop in coal consumption, mainly at the expense of lower demand and higher gas-fired generation. Solar power is growing by leaps and bounds, though it still has a ways to go to catch up with wind and has already started to attract a similarly mixed reception as it moves beyond rooftops into utility-scale installations.

Meanwhile, another big renewable energy sector was kept on life support by the steadily-expanding US Renewable Fuel Standard and a 30-year-old subsidy that has outlived its usefulness. Despite this support and an import tariff designed to confine that subsidy to US producers, 2009 continued the previous year's trend of ethanol suppliers going bust. It also saw the largest of the previous year's ethanol bankruptcies progress to liquidation, as most of VeraSun's facilities were ultimately absorbed by independent refining giant Valero, which also became an active investor in next-generation biofuel technology. Yet in spite of its continued growth and the unwavering support of federal and state governments, corn-based ethanol is hurtling toward a collision with the 10% limit on blending it into a shrinking gasoline pool--a limit that ethanol supporters want to have raised to 15%, regardless of the consequences for consumers. An even bigger problem lurks for corn ethanol, which has lately been promoted for its contributions to reducing emissions. The evidence is mounting that on a global basis its emissions might even be worse than from the petroleum products it displaces. The greater our commitment to addressing climate change and sustainability, the larger the contradictions of corn ethanol will loom.

And that brings us to Copenhagen, which served as the year's great energy anti-climax. While the outcome is being touted as a "Big Step Forward," the session in Denmark failed spectacularly to deliver the expected culmination of the two-year timeline set at Bali and built upon in a series of interim meetings. Instead of a binding global treaty to replace the expiring Kyoto Protocol, the Copenhagen Accord looks like a joint promise to make a list of independent targets--a promise that was only purchased with commitments for future aid that may never materialize, or that may only come at the expense of existing forms of aid to the developing world. With action on climate legislation in the US Congress stalled for now--for good reasons, in my view--that was probably all that could realistically be accomplished. Yet it still falls short of any objective metrics for judging the session, and indeed the entire Conference of the Parties (COP) process. I wouldn't be surprised to see the COP marginalized by the Major Economies Forum, an initiative that adds the EU central government to the group of large emitters first convened by the previous administration. When the COP manifests the dysfunctionality of the UN General Assembly, then climate change needs its own version of the Security Council to get things done.

Neither Copenhagen nor Climategate spells the end of action on climate change, but they might just mark a turning point toward a more pragmatic and less dogmatic set of responses, perhaps along the lines of a compromise being floated in the US Senate that would consider the contributions of all forms of energy to a more secure energy future with lower emissions. That aligns with the gradual replacement of a narrative of oil scarcity by one of natural gas abundance and the deft use of renewables, with a much stronger emphasis on efficiency and conservation, which still look like the low-hanging fruit for both energy security and climate change.

Barring major events, this will be my last posting for the year. Best wishes for a happy and healthy New Year.

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Indexing Crude Prices

Although oil trading hasn't been my primary focus for many years, the recent announcement by Saudi Aramco that it is switching its price mechanism for oil delivered to the US caught my attention. Instead of basing its formula for deliveries here on the price of West Texas Intermediate crude oil, it will apparently reference the new Argus Sour Crude Index (ASCI.) While that lends substantial credibility to this new index and may gain Argus more than a few new subscribers, the implications for the widely-traded NYMEX WTI contract and the dynamics of the broader international oil market seem much less clear. In particular, I am skeptical of suggestions that this move could ultimately reduce whatever influence non-commercial financial participants--speculators, in common parlance--have on oil prices.

The question of how best to price crude oil for buyers and sellers is a perennial problem, particularly for oil that differs significantly in quality from the light, sweet grades behind the extremely liquid WTI and ICE Brent futures contracts. US refiners, in particular, have invested many billions of dollars in the hardware required to turn lower-quality oil into high-quality petroleum products. Any time the peculiarities of these contracts drag up the prices of the grades of oil they prefer to run, they grumble about basing deals on WTI. Likewise for sellers of sour crude, foreign and domestic, who suffer when the WTI price moves out of sync with world prices, such as when storage at its nexus at Cushing, OK fills up, as it did earlier this year. However, after listening to the Q&A podcast concerning the ASCI on Argus's website and reading the background document there, I'm skeptical that this index will settle the sour crude market's discontent, because it won't change the way this oil is traded by nearly as much as it might appear.

Without getting into all of its details, as I understand it the ASCI is effectively a composite daily report of the deals done for three specific streams of offshore Gulf of Mexico crude oil, all of which trade at a differential to WTI. In calculating a daily price, Argus will add the average daily discount or premium vs. WTI from the transactions it learns of to the daily price for WTI to come up with a single price in dollars per barrel. The Argus podcast was very clear that NYMEX WTI is still as the heart of the new index, not just because this reflects the way deals are done with reference to WTI, but also because WTI remains the highly-liquid futures contract that the buyers and sellers of the ASCI oil streams use to hedge their market risk. In other words, the new ASCI index is not a substitute for WTI-based pricing, but merely a more transparent gauge of the relationship between WTI and the sour crude market--though an index you have to pay to read falls a bit short of the kind of transparency currently provided by WTI itself.

What would happen if speculators drove up the price of WTI by $30/bbl? In theory, ASCI would reflect any disconnection between the fundamentals-based pricing of its included sour crude streams and the financially-driven WTI market by remaining more or less unchanged, after summing the combination of correspondingly wider discounts for the ASCI grades to the inflated daily WTI prices. Only by looking at the differentials themselves would we see any indication of distortion of the market by non-commercial players. But is that realistic? Consider that between January 2007 and July 2008, when the price of WTI rose more or less steadily from the mid-$50s to nearly $150/bbl, the discount between WTI and the monthly average refiner acquisition price for imported crude only widened from around $4.75/bbl to roughly $9/bbl. If WTI was being driven by speculation in that interval, differentials-based trading of the kind that ASCI will measure hardly insulated refiners from its effects.

That historical result might merely indicate that speculation had little real effect on the market in that period--a view to which I'm sympathetic--but it might just reflect the inertia of negotiated crude differentials. Either way, if you're Saudi Aramco and you're selling crude into the US based on ASCI, I'd conclude that your prices would still go up more or less in tandem with the NYMEX, despite the superficial "arms-length" mechanism flowing through ASCI. Perhaps I've missed some subtlety in the mechanism.

From what I can tell, neither ASCI nor the prospect of new futures contracts based on it addresses the underlying concerns I have had since the industry migrated to pricing based on differentials against the WTI and Brent futures contracts, and away from negotiating actual "fixed and flat" prices for each cargo or pipeline deal, back when I was trading oil in the 1980s and early 1990s. While that shift made life much easier for risk managers and took a lot of heat off traders to strike the best deal on any given day, it also opened the door to a host of other influences on pricing that I still don't think we entirely understand.

The market will pass its own judgment on ASCI and other new tools like it. If it proves useful to traders and risk managers, it could become the new industry standard, as Argus must hope, having made such a big splash over its launch. If it's not useful, it will fade into the background, becoming just another dataset in an already bewildering sea of energy-related information. With Gulf of Mexico output booming and more discoveries yet to be made, it looks like a reasonable bet to join other useful physical crude indices around the world. But anyone hoping it will shine a beacon on speculators in the next oil price spike is likely to be disappointed by the core of a system still rooted in WTI, the speculative influences over which remain uncertain and possibly unprovable.

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Overproducing US Oil?

Tuesday morning I dialed into an API media teleconference concerning the administration's latest proposals on energy taxation and access. During the call API's President, Jack Gerard, mentioned the recent Congressional testimony of a Treasury Dept. official who suggested that current policies were promoting "overproduction of US oil and gas." That remark struck me as so absurd that I later asked for the reference, so that I could confirm what had actually been said. In fact, the written testimony of Alan Krueger, Assistant Secretary for Economic Policy and Chief Economist of the US Treasury, before the Subcommittee on Energy, Natural Resources and Infrastructure of the Senate Finance Committee included that statement and others in a similar vein. According to Dr. Krueger, the US oil & gas industry has benefited from a set of tax policies and incentives that have steered too much of the nation's capital investment towards energy and away from other sectors. In his view, removing those incentives would increase federal revenue by some $30 billion per year and create a "level playing field" for other forms of energy, while resulting in only insignificant reductions in US oil & gas output, with a negligible impact on our energy security. While his opinions might be shared by plenty of Americans, they reflect an excessive adherence to theory, ignoring the geopolitical circumstances in which global energy markets operate. And on a more basic level, his numbers don't even add up.

It's hard to know where to begin in analyzing Dr. Krueger's remarks. Perhaps the best starting point is the limited zone of agreement between his views and mine. From his comments about greenhouse gas emissions, I assume we share a deep concern about climate change and the contribution of fossil fuels to this problem. Reducing our emissions will require us to consume progressively less of these fuels in the years ahead, and improved energy efficiency and alternative energy production are important strategies for achieving that result. However, Dr. Krueger seems to believe that constraining domestic oil & gas production is another appropriate strategy for addressing climate change. I hope that view is merely his own and not widely shared in the administration, because it represents a horribly inefficient way to reduce emissions, at a shockingly high cost to the US economy. As I've noted many times, most of the emissions from oil and gas come from their consumption, not their production, and merely offshoring the upstream emissions associated with the oil and gas we consume would do nothing at all for global climate change, while reducing US economic output, employment, and energy security and increasing our trade deficit. In this regard the needs of energy security and climate change are perfectly aligned on the necessity of reducing our use of imported oil. Domestic oil and gas are not the enemy; they are part of the solution, and no reasonably informed person would suggest we produce too much oil.

Then there's the notion of a "level playing field," which in this case is fatally flawed for at least two reasons that should be obvious from the most cursory inspection of the issue. First, the global oil market does not conform to anyone's notion of a level playing field. The chief economist of my old firm used to preface many of his comments on oil prices by reminding his audience that the entire oil market was based on turning conventional economics on its head. If the oil market matched economic theory, the lowest cost producers would be going flat out all the time, and only enough high-cost oil from places like the US, UK, etc. would turn up to balance supply & demand. On that basis, I imagine OPEC would be producing 70 or 80% of the world's oil, and the US wouldn't be importing 57% of our crude oil needs, but perhaps 90%, because many US producers would slide right off the edge of that level playing field. Of course that wouldn't be a problem, because in that pure world no OPEC member would ever think of cutting output to raise prices, or of using oil as a geopolitical lever.

The other obvious fact undermining Dr. Krueger's hope for a level playing field arises from his administration's own policies--and those of the last several administrations--with regard to renewable energy. We have tilted the playing field quite far from the level in favor of corn ethanol and electricity from wind and a variety of other renewable sources. Putting all of these incentives into common, more familiar units might help to illustrate just how un-level we have made the field. Consider ethanol, which receives a Volumetric Excise Tax Credit, a.k.a. "blenders' credit" of $0.45 per gallon. That's $18.90 per volumetric barrel, though when we adjust for ethanol's much lower energy content compared to petroleum products, it works out to an effective rate of $32 per barrel of oil-equivalent energy (BOE). Wind power and other renewable electricity sources are eligible for a federal Production Tax Credit of $0.021/kWh generated. Assuming that they back out mainly power generated from natural gas, that works out to an effective subsidy of $2.33 per million BTUs (63% of the current spot natural gas price) or $13.40/BOE. Now let's compare those figures to that $30 billion the government could collect by closing tax loopholes that benefit oil and gas.

If you have a gut feeling that the subsidy per BOE of oil and gas would be much lower than for renewables, give yourself a gold star. The reason the incentives in question are lower is that the denominator is so large. When you add 2008 US domestic production of crude oil, natural gas, and natural gas liquids on an oil-equivalent basis, it works out to a shade over 6 billion barrels. As a result, that $30 billion worth of incentives equates to just $5 per barrel, or 12 cents per gallon, which is not only less than the incentives for renewable energy--the production of some of which appears to be no better for the environment than oil--but also less than the federal excise tax on gasoline. And while Dr. Krueger expressed concern that US lease terms for offshore oil production in the Gulf of Mexico were more generous than those of other producing countries, he does not appear to have factored in the effective 40% federal income tax rate on the earnings of the companies producing oil & gas from those fields.

Now, I can't say that taking $5 per bbl away from the domestic oil & gas industry would cripple it. At this point, the industry is pretty healthy, though not nearly as healthy as it was a year or two ago. But even in a world of $70 per barrel oil, and with US natural gas currently trading at a much lower equivalent price of $21/bbl, that $5 looks like a significant deterrent to investing in more production here--production that would contribute essentially net-zero to global greenhouse gas emissions but that would back out foreign oil and gas imports on a direct, barrel-for-barrel basis. With a lifetime of experience in that industry, I don't need an economic model to know that Dr. Krueger's estimate of losing only "one-half of one percent" of domestic oil & gas output defies common sense and looks suspiciously like a manifestation of "garbage in, garbage out".

There is legitimate debate over the best way to address the externalities associated with our use of oil and gas and the emissions they create, and I come down squarely on the side of recognizing the emissions externality via the mechanism of cap & trade--though not in the grossly-distorted
form inherent in Waxman-Markey. That's an entirely different kettle of fish than making US hydrocarbon production less competitive with the imported oil and gas with which it must contend, in a global market that is anything but level, thanks to OPEC and the consequences of resource nationalism. A quick review of Dr. Krueger's impressive bio suggests that his main expertise lies in the economics of education and labor. It is clearly not in energy. We live in a world in which the geopolitics of energy are so challenging, and in which the EU subsidizes airliners, while China apparently subsidizes tire makers, and any number of countries--now including ours--subsidize carmakers. In that context, a modest level of incentives for the production of domestic energy from a variety of sources, including oil and gas, doesn't look so extraordinary. If anything, it's sensible and prudent.

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Rebound or Dead Cat?

US light sweet crude oil closed above $50 per barrel yesterday for the first time since late November. The financial press appears to attribute this mainly to the weakening of the dollar and inflationary expectations triggered by the Federal Reserve's decision to purchase over a trillion dollars of securities, in a bid to reduce longer-term interest rates. Although I don't discount these concerns, a review of oil's fundamentals suggests there are other factors at work, as well. The recovery in oil prices from the mid-$30s has involved more than a one-day rally, nearly a dollar of which had abated as of this morning. It is hardly the kind of rebound we might expect once the recession eases, but if it is sustained it should remind consumers that the current price relief on petroleum products is temporary, while sending producers a positive signal on the need for continued resource development.

Yesterday's weekly statistics from the Energy Information Agency showed that US inventories of crude oil and its two main fuel products, gasoline and distillate (diesel/heating oil), continue to build. But while distillate demand remains very weak, reflecting the decline in goods movement that accompanies a slowdown in economic activity, calculated gasoline demand has returned to within a percent or so of its year-ago level. Gasoline imports are running at a million barrels per day. All of this provides refiners some welcome headroom for their traditional spring-time switch into maximum-gasoline mode, after having optimized on distillate production during the winter. If demand were still as weak as it was a few months ago with gasoline inventories this high, any rally in oil prices would quickly extinguish itself.

Weakness in the dollar relative to other key currencies can also drive crude prices higher. This effect contributed to the extraordinary spike in oil prices from mid-2007 to mid-2008. But many of the factors that fed the resulting "oil-dollar price loop" look too anemic now to create a sustaining pattern of this type, amid the global recession and credit crunch. A slight decline in the Euro or Yen price of oil seems unlikely to stimulate much demand. Unless the dollar continued to weaken progressively, turning its recent 8% slide against the Euro into something more serious, it's hard to see this sustaining higher oil prices against the fundamentals.

The notion of oil as an inflation hedge is another matter. Traders aren't the only ones who get the jitters at the thought of the US government printing money to buy its way out of our current problems. However, inflation worries seem premature when deflation remains a serious risk. The latest report on seasonally-adjusted US consumer prices showed "core inflation"--excluding food and energy--rising at a sub-2% clip, while the three-month and twelve-month averages for the prices of all items are still in negative territory. The whole point of the stimulus bill was to soak up the enormous slack capacity in the economy, and until that begins to bite, the idea of too much money chasing too few goods seems a remote prospect. Nor did oil work out very well as an inflation hedge last summer, when the CPI was growing at more than 5% per year.

And that brings me back to oil's fundamentals. The fact that the market didn't swoon when OPEC met and decided to defer further cuts suggests that they have reduced output sufficiently--and are living up to their lower quotas well enough--to create an environment in which events such as the Fed's move can be seen as bullish. It wasn't long ago that it seemed nothing could drive up oil prices for more than a day or two. At the same time, oil's recent moves haven't flattened out the remarkable degree of "contango" that I observed in December. Oil futures for delivery twelve months from now are $10/bbl higher than the front-month price. That suggests the market is still weighed down by high inventories and tight credit, impeding the obvious arbitrage opportunity such wide spreads create. A more dramatic rebound in oil prices must still wait for the global economy to begin to turn around and draw down that overhang. In the meantime, though, the 50% appreciation of oil from its low on February 12th looks like rather more than the proverbial bounce of a dead cat.

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The Right Price

So OPEC has kicked the can down the road another two weeks, deferring further production cuts until at least their December 17th meeting in Algeria, when they can better assess the impact of the cuts they've already made--code for observing how badly its members have cheated on their earlier quota reductions. As usual, the cartel's control over prices is much stronger when demand is surging and production capacity strained, than when markets develop considerable slack. This is a much-rehearsed dance, and the market has apparently already discounted it, with the price of light, sweet crude poised to test the $50 mark again this week. The more interesting commentary out of Cairo concerned OPEC's desired price, which is apparently $75 per barrel: well above today's level but far below summer's peak. Wishing won't make it so, but there has been much discussion lately about the "right" price for the most liquid of energy commodities.

I can't help observing the irony that $50 oil, the prospect of which seemed nearly inconceivable to seasoned industry experts only a few years ago, now looks too cheap, not just to OPEC, but also to producers of unconventional oil, developers and supporters of alternative energy, and those concerned about climate change. When you dig a little deeper, however, the insight here seems to be that the absolute price matters less than its volatility, at least from a planning perspective. It's hard for producers of all kinds of energy to plan their business, if the monthly average price of their output--or the key commodity affecting it--can spike up by 150% and then drop by 60%, all within the course of two years. Oil remains a cyclical business, as anyone who's been around it for a while understands, but this is ridiculous.

That $75 per barrel figure from OPEC is interesting for many reasons. It probably represents the minimum level needed to balance the considerable budgetary expansions taken on by its most aggressive spenders, such as Venezuela and Iran, along with pseudo-member Russia. But it also looks like the level that is required to keep additions of new unconventional oil capacity, such as Canadian oil sands, on track. With typical refining margins, instead of the bizarrely-inverted pricing we've seen recently, it would translate into an average gasoline pump price in the US of around $2.50/gal. And because US ethanol distillers are producing well beyond the volumes required to satisfy the federal Renewable Fuel Standard, that would yield an ethanol price after subsidies in the neighborhood of $2/gal., enough to give ethanol producers a 75 cent per gallon "crush spread" over corn at $3.50 per bushel. That's a lot better than the 40 cents or so implied by the current ethanol and corn futures prices.

If the drop to $50 were short-lived, most of those energy producers would experience little lasting impact, other than ethanol firms that have been pushed to the brink by the combination of overly-rapid expansion, tightening credit, and slumping prices. But looking ahead, no one can say with any certainty whether oil will remain here, test $40/bbl, or zoom past $100 again next summer. In this regard the futures market, which last week reflected prices above $70/bbl. beyond 2010, has been a very poor barometer. Nor have the forecasts of government departments or international agencies fared any better at anticipating the volatility that is so disruptive to economies and to the plans of energy companies and oil-exporting countries.

Consumers are in the best position of anyone affected by these developments. If you drive an average car an average amount, your fuel bills ought to be about $90 per month lower than they were in July, which is the equivalent of a $120 per month raise for anyone in the 33% combined federal income and social security tax bracket. Save it or spend it, but don't count on it lasting longer than a year. That means buying your next car with the prudent assumption that at some point in its life, you will be paying $4 or more per gallon, once again.

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