What Won't Change After the Election?

Tomorrow's US mid-term election dominates today's headlines, with most analysts expecting a dramatic shift in control, at least in the House of Representatives. However, from an energy perspective, many aspects of the situation in which we will find ourselves after the ballots are counted will remain largely predetermined for the next two years, going into the 2012 election. As candidates debate differing perspectives on energy it's worth recalling the tremendous inertia of our energy systems. The seeds of significant change have already been planted and are promoting a gradual transformation, but the results will be more evident when we look back at the end of the decade than while it is underway.

One given is that for at least the next two years, fossil fuels will continue to supply well over 90% of US transportation energy and more than 2/3rds of US electricity generation, with nuclear and conventional hydropower accounting for more than 80% of the low-emitting remainder. Even though wind and solar power are still growing rapidly, though the former has slowed down appreciably compared to last year, they are still too small to make a significant difference in our consumption or emissions, and that will remain the case in 2012. Advocates of wind power and other renewables lament the lack of comprehensive energy legislation or a more focused national renewable electricity standard, but weak fundamentals have at least as much to do with the slowing rate of wind installations. US electricity demand has recovered somewhat from its low point last year, but it remains around 2% below its high of 2007. That has made utilities more reluctant to add generation of any kind, particularly in light of the strong emphasis on efficiency measures in the policies enacted in the last several years, starting with the Energy Independence and Security Act of 2007 and reinforced by last year's stimulus.

Another given is that oil will continue to dominate our concerns about energy security. The economic slowdown reduced net US imports of crude oil and petroleum products by 20%, compared to 2007, but even at this level imports are still a third larger than domestic production of crude oil and natural gas liquids--a disparity that is set to grow for two reasons. First, the greatly reduced rate of drilling in the Gulf of Mexico following the Deepwater Horizon disaster and the moratorium that was imposed in response is already starting to reverse the gains in US oil output that we saw in the last several years. Mature offshore fields are declining, while new projects will be slower to come online. Not even the remarkable success of onshore drilling in the Bakken formation of the Dakotas and Montana, which has moved North Dakota up to number four among oil producing states--past perennial heavyweights like Louisiana and Oklahoma--is likely to compensate for slower growth from the Gulf.

Nor are biofuels likely to add enough production in the next two years to avoid an increase in our oil imports, as ethanol approaches the limits of corn ethanol output and faces the expiration of the tax credit it has enjoyed since 1978. And while the proliferation of hybrids, electric vehicles and other efficient car models is a step in the right direction, their numbers are too small for now to counteract any increase in miles traveled. Even a modest amount of demand growth from a recovering economy will set US oil and refined product imports climbing again, with a corresponding impact on world oil prices and our trade deficit.

There's little doubt that the incoming 112th Congress will have a different approach to energy and its related environmental issues than the outgoing 111th has had. That could prove significant for many aspects of US energy policy, including climate policy. At the same time, the new members of the House and Senate are likely to find, as past Congresses have, that our energy challenges are less responsive to intervention than they assumed. I wouldn't be surprised if the biggest impact on energy in the next two years comes not from energy legislation, but from the indirect effect of whatever steps are taken to address our larger economic problems.

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Oil Plumes and the Fate of the Spill

I'm as reluctant to insert myself into the debate over what happened to all the oil that leaked from BP's Macondo well between April 22 and July 15--when the second cap stopped the flow--as I was concerning the earlier controversy regarding flow-rate estimates. At the same time, I find the coverage of this story lacking in crucial details that could help us to understand how much of the oil evaporated into the warm air of the Gulf or degraded naturally, how much was collected, and how much potentially remains in the sea. The assessment issued by the National Oceanic and Atmospheric Administration (NOAA) on August 4, 2010 has been disputed by some scientists, and reports of lingering oil plumes add to the public's apprehension that the pieces don't quite add up. But although I don't have nearly enough information to conclude which group is closer to being right, I feel much more confident in pointing out where their arguments seem weak.

Let's begin with the estimate of the total quantity of oil leaked into the Gulf, which lately seems to have become cast in stone at 4.9 million barrels (205.8 million gallons.) This is the crucial starting point for any analysis of how much of it remains in the Gulf. This figure appears to be based on the estimate by the Flow Rate Technical Group of an average rate of around 58,000 bbl/day for the 85 days that the well was leaking. NOAA indicates an uncertainty for this figure of +/- 10%, but with all due respect to the scientists who worked on it, that seems excessively precise for something that was never measured directly.

There are only two ways I know of to measure such a flow, as distinct from estimating it. The most accurate involves gathering all the oil flowing during a given interval--say, a day--and gauging the tanks into which it flowed at the beginning and end of the interval. From a quick review of the transcripts of BP's technical briefings, it appears that the largest quantity of oil that was actually collected in a 24-hour period equated to a flow rate of about 24,000 bbl/day, though this represented only a portion of the total flow, with the remainder continuing to leak into the sea due to containment limitations. So we know the rate must have been higher than that figure, but not how much higher. The other way to measure oil flow is with a flow meter. It's a pity that BP's "Lower Marine Riser Package", the second cap and valve assembly installed on the well, didn't include this capability. I don't even know if it would have been feasible, given the pressures and high flows of oil and natural gas involved.

In the absence of direct flow measurements, the Flow Rate Technical Group had to rely on sophisticated techniques for calculating the flow, based on the observed velocity of the fluid leaving the well and a complex set of assumptions--grounded in a limited amount of actual data--concerning the gas:oil ratio of the fluid, the rapid expansion of the gas coming out of solution within the space over which the velocity was determined, as well as the changing pressure and temperature within this regime. Tricky stuff, particularly considering how much of the observed flow was attributable to gas, rather than oil, as I noted in May. I'd also note that since the estimated 58,000 bbl/day flow rate is at the top of the range of flow rates observed from other oil wells in the history of the industry, it's quite possible that the range of uncertainty for the total amount leaked is not only wider than +/- 10%, but also non-symmetrical, with more downside than upside. I'm sure we will hear much more about this in the future, not least because the size of the fine BP would ultimately pay for the leak depends on it. That's not the concern of the moment, however.

The pie chart in NOAA's report indicating the breakdown of the different fates of the oil that leaked has gotten a lot of scrutiny. Some reports have interpreted it as indicating that only a quarter of the oil remains in the marine environment. I wouldn't read it that way. Instead, I'd see three distinct categories for the oil's current status. The first and least ambiguous concerns the oil physically collected directly from the well, skimmed from the surface, or burned off, constituting an estimated--and only partly measured--25% of the uncertain total discussed above. This oil is clearly no longer in the water. The next category is oil that is likely no longer in the water, and that is the portion of the "Evaporated or Dissolved" segment that evaporated. If the oil had all reached the surface, I wouldn't be at all surprised if most of that segment should be attributed to evaporation; this was, after all, light, sweet oil with a high proportion of volatile fractions. The problem is that we don't know how much of the oil that leaked a mile down made it to the surface. The portion that didn't, which in NOAA's parlance was dissolved, naturally dispersed or chemically dispersed--potentially up to 49% of their total estimate--could still be in the water column, along with the 26% "Residual"--less the unknown portion actually broken down by bacteria and other processes. And it's some of this remaining oil that makes up the plumes we've been hearing about.

The undersea oil plume currently in the news was found in June by scientists from the Woods Hole Oceanographic Institute. They describe it as being at least 22 miles long, 1.2 miles wide, and 650 ft. high. The total volume of the plume, assuming it filled that entire rectangular solid, would be about 3.6 trillion gallons. However, the critical data point that I didn't see reported in any of the newspaper accounts I read was the concentration of oil in that water. According to the report on the Woods Hole site, the concentration of specific oil-derived molecules ("BTEX") is "in excess of 50 micrograms per liter". Adjusting for the density of the chemicals in question, that means that they found oil-related concentrations of approximately 57 parts per billion by volume. So by my math, the total volume of these chemicals within the plume is on the order of 200,000 gallons, or under 5,000 bbl. Unless these chemicals are only the tip of the iceberg in terms of oil derivatives in the plume--and Woods Hole hints that there is more--then we're talking about less than 0.1% of the 4.9 million barrels estimated to have leaked into the Gulf. In other words, while a plume like this might be potentially serious for aquatic life, it's not clear how much doubt its existence casts on NOAA's analysis of where all the oil went.

I will be very interested in seeing further refinements of all these estimates in the weeks and months ahead. Perhaps the media will even include more of the details crucial for putting it into perspective.

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Rejecting Reactive Energy Policy

I see that BP now thinks it might be able to cap its leaking Macondo well this month, rather than sometime in August, barring a major hurricane or other disruption. That can't come a moment too soon, and not just for the obvious reasons. Every day that the well continues to spew oil into the Gulf of Mexico contributes to the mounting appearance of panic among policy makers, who have allowed--willingly or otherwise--the oil leak to hijack our progress towards a sensible energy policy that addresses both energy security and greenhouse gas emissions, based on a rational assessment of the tools available now and the timing of future options. The sooner the oil spill is off the front page, the sooner work can resume on that effort.

One of my old commodity-trading mentors liked to remind his more junior colleagues to "sell the news and buy the facts." By this he meant that those who get carried away by the emotion of current events are liable to be whipsawed when reason returns with a little time and perspective. More than a few members of Congress and the administration could benefit from that insight right now, as the understandable reaction to the oil spill whips up exaggerated rhetoric concerning our addiction to oil and the prospect of ending it sometime soon. Funny that we don't hear much about Europe's addiction to oil, which at least in terms of its relative reliance on oil imports looks even more serious than ours, despite astronomical motor fuel taxes and an emphasis on biodiesel that nearly matches our focus on ethanol. Since Europeans have consistently focused on this problem for years, perhaps it's just not as easy to solve as some Representatives and pundits imagine. If that's true, does it make sense to divert our focus away from a comprehensive approach to both emissions and broadly-defined energy security, in order to zero in on the most daunting element of both concerns?

First consider the oil-security portion of the problem, which in many ways was clearer in 2008, when oil prices zoomed past $100/bbl and headed for $150, until both they and the economy broke later that year. Americans got the message that conservation and efficiency were the top priorities for dealing with the cost of our oil addiction. The oil spill doesn't alter that. Although prices have come down considerably since mid-2008, they remain well above the pre-2004 level of $20-30/bbl or so, when gasoline was consistently under $1.75/gallon. As a result of those pressures, motorists cut back on their driving, and the Congress enacted--and this administration implemented--the most significant increase in Corporate Average Fuel Economy requirements in a generation, taking the new-car average CAFE standard to 34 mpg by 2016, including both passenger cars and light trucks/SUVs. Based on forecasts by the Energy Information Agency of the DOE, these rules, along with prudent conservation, should reduce US gasoline consumption by 2.6 million barrels per day by 2030, compared to pre-CAFE forecasts. And although I've disagreed with some of the specifics of these regulations, particularly for failing to correct outdated assumptions and allowing carmakers to double-count the benefit of electric vehicles, these new standards will eventually transform the US vehicle fleet and the energy it consumes.

We also shouldn't allow our revulsion at the oil spill to blind us to the emissions implications of our energy choices. In 2008 oil accounted for over 37% of US primary energy consumption and 35% of our greenhouse gas emissions, while coal contributed 22.5% of primary energy but 30.5% of emissions, including a whopping 91% of the CO2 emissions from the electric power sector. That distinction is crucial, because while we still have limited and only partially-effective substitutes for oil in transportation, where most of it is used, we possess a wide array of options for reducing the emissions from electricity generation, which consumed just 1.3% of total US oil demand last year. Several of these are economically viable today, though most require some level of subsidies or incentives. Nuclear power and geothermal energy are effective low-emission alternatives for baseload generation, while natural gas and renewables are already making significant inroads into coal's market share of overall power demand. And if implemented on a large-scale, integrated basis, carbon capture and sequestration could enable coal to continue to compete in a low-carbon electricity marketplace.

None of this suggests a return to the pre-spill status quo. The impact of the spill on the oil industry and the regulations that govern it will be significant and long-lasting, as it should be. At the same time, it would be hard to assess all of the public evidence assembled so far and not conclude that the accident that destroyed the Deepwater Horizon rig and led to the uncontrolled leak of many thousands of barrels per day of oil into the Gulf was entirely preventable--not by a ban on drilling in deep water, but by prudent adherence to sound operating principles and practices and the consistent enforcement of regulations to ensure that adherence by even the least-cautious operators. Yet as necessary as creating a universal culture of safety and caution in offshore drilling is, we can't let this urgent task divert our attention from the important long-term drivers of US energy policy and the actions--many already underway--necessary to address them. Good energy policy can handle all of this, while overly-reactive policies focused on the Macondo spill and the political opportunity it presents risk misallocating our priorities and creating a legacy that would make our long-term energy situation even more challenging than it already is.

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Expand the Presidential Commission on Deepwater Horizon

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

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

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

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

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

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

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

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Walruses and Wake-Up Calls

I just finished watching today's hearing on offshore drilling operations and safety by the Energy and Environment Subcommittee of the House Energy & Commerce Committee, featuring the CEOs of ExxonMobil, Chevron, and ConocoPhillips and the US heads of Shell and BP. Rather than giving in to the temptation to deliver a rant on the current level of dysfunction in Congress, I want to highlight a few things that stood out for me in the testimony of the assembled chiefs of the largest oil companies in the US, and then focus on the central dilemma that was explored in the hearing.

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

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

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

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The Fate of BP

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

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

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

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

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

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

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

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

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

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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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Ethanol and the Gulf Spill

The implications for the oil industry from the ongoing Gulf of Mexico oil spill are already taking shape, with the administration calling for a Challenger-style investigation and rewriting the playbook for oil & gas leasing and the issuance of safety and environmental permits for offshore drilling. It's less clear how the spill might affect other aspects of energy, beyond boosting the public's interest in pursuing clean energy options. However, it would be ironic if a problem perceived to have arisen because of a "cozy relationship" between oil companies and regulators resulted in an even cozier relationship between the government and the ethanol industry that depends on it for both financial support and the rules that mandate the use of its product. Yet that's exactly what could happen as the administration decides whether to increase the allowable percentage of ethanol in gasoline.

Perhaps you've seen the new ads from Growth Energy, an ethanol trade association: "No beaches have been closed due to _____ spills", with the word "ethanol" fading slowly into view. Then there's "We won't have to wait millions of years to replenish our _____ reserves," and other statements emphasizing ethanol's employment and energy security benefits. It's a clever campaign, and well-timed. On one level, using more ethanol in gasoline seems an obvious response to concerns about our dependence on oil. For all its many shortcomings, ethanol remains the most successful oil substitute in the US market, thanks to the combination of a $0.45 per gallon blenders' tax credit and the steady ratcheting-up of the annual federal renewable fuels standard. Ethanol currently displaces the equivalent of approximately 500,000 barrels per day of gasoline that would otherwise be imported or refined here from imported crude oil. The problem is that the market penetration of ethanol is rapidly approaching the 10% blending limit that has been approved as safe for use in engines that haven't been modified to run on higher-percentage ethanol blends, such as E85. And because E85 has so far failed dismally to take off--accounting for just 0.01% of US gasoline sales in 2008, based on EPA's analysis--any additional ethanol would have to be squeezed into ordinary gasoline, at least in the near term.

Our proximity to this threshold, referred to as the "blend wall", is determined by two factors, in addition to the federally-mandated ethanol blending volume: total US gasoline sales and US ethanol output. Last year Americans bought just under 138 billion gallons of gasoline (including the ethanol blended into it), a reduction of about 3% from the 2007 peak. Without further growth in demand, 10% of that would be 13.8 billion gallons per year (gpy). According to the Renewable Fuels Association, another ethanol trade association, the capacity of existing US ethanol facilities plus those under construction already totals 14.7 billion gpy. In other words, once all the ethanol plants now being built are finished, the industry could supply more than 10% of US gasoline demand without breaking a sweat. But without either a higher blending limit in gasoline or a sudden, unexpected surge in E85 sales, any additional ethanol beyond that level would have no home in the US fuels market. Nor is it obvious that corn ethanol exports represent a viable long-term outlet. Left unresolved, this is a guaranteed train-wreck.

Under the circumstances, it's natural for the ethanol industry to ask its patron for help, in the form of a request for a waiver to blend more than 10% ethanol into each gallon of gas. Last winter, the Environmental Protection Agency told Growth Energy that it was studying their request and would respond by mid-2010. That deadline is nearly upon us, and with more oil spilling into the Gulf of Mexico every day, the pressure on EPA to agree must be mounting. This can't be an easy call to make, especially with the auto makers citing test results indicating that ethanol blends above 10% could harm some car engines. Saying no would call into question the nation's entire long-term renewable fuels strategy, at a time when green jobs and green energy are being widely promoted as the key to a new, more competitive economy. Yet granting that request, either as a favor to the ethanol industry or as a hasty response to the Gulf Coast oil spill would be a mistake that could have serious repercussions, both for consumers and for the administration making such a call. Stay tuned.

Update as of 6/18/10: EPA delays its decision on E15 until the fall.

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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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