The Commission Finds...

I've been skimming through the report of the presidential commission on the Deepwater Horizon accident. Lacking time to read every word, I'm finding it on the whole a moderate document. By that I mean that it will not satisfy either those who expected the commission to repudiate deepwater drilling entirely or those that harbored faint hopes that it might issue a blueprint for a rapid return to drilling incorporating the key learnings of the disaster. Instead, as a number of observers have pointed out, its findings point to a complex web of contributing factors--in the process implicating the entire industry--and its recommendations suggest a thicket of new regulations and added fees for oil & gas exploration in US waters.

Anyone awaiting gleaming insights and Ah-ha! moments such as those that exemplified the Rogers Commission's investigation of the space shuttle Challenger accident was bound to be disappointed. With no commissioner having direct knowledge of the theory and practice of offshore drilling in the way that the Rogers Commission included some of the leading lights of the US aerospace community at the time, there was no one to lead it to such results, only paid technical staff to carry out the guidance of a team led by professional politicians. That's not as bad as it sounds. Given the breakdown of what little trust existed for the oil & gas industry, a commission made up largely of experienced oil executives, petroleum engineers and geologists would have lacked credibility with governmental decision makers and the public. However, the composition of the commission surely presaged the outcome of its work.

In the foreword to the document, which is probably all that many will ever read, I was reassured to see a broad recognition of the importance of petroleum to the US economy, the challenges involved in moving away from it, and the necessity of exploiting the resources of the Gulf of Mexico. The commission also pointed out that our conscious decision to focus offshore drilling in the Gulf and not elsewhere carries risks--a surprising admission considering that one of the commission chairs played a significant role in the establishment of that policy. However, I was disappointed at the sweeping indictment of the practices of the entire industry.

The commission was neither tasked nor staffed to investigate the entire US offshore drilling community. Such an undertaking would have required either years or a much larger effort. The parallel to the implication that because most of the industry uses the same contractors, then most of the industry must operate in a similarly risky manner would be as if the Rogers Commission had found that because most rockets and many aircraft were built with components from the same suppliers, most rockets and aircraft must be as risky as the shuttle proved to be. That logic is shaky, at best.

My own experience in the industry doesn't qualify me to pass judgment on the overall quality of the commission's investigation or the full implications of its technical and procedural recommendations. However, in my quick perusal of the document several points jumped out at me that seemed to reflect a limited perspective. I'll highlight two examples.

First, with regard to the risk of fatalities on offshore facilities, the report concludes that "From 2004 to 2009, fatalities in the offshore oil and gas industry were more than four times higher per person-hours worked in US waters than in European waters, even though many of the same companies work in both venues." This was backed up by a chart on page 228 comparing these statistics from several sources. Yet while every fatality is one too many, and no one should be complacent about them, I was astonished that it didn't seem to have occurred to the commission's staff to compare these accident statistics to the US industrial safety statistics, either overall or in similar industrial settings. In a brief Google search I turned up the "Census of Fatal Occupational Injuries Summary, 2009" from the Bureau of Labor Statistics of the US Dept. of Labor. Converting the average US fatal work injury rate of 3.3 per 100,000 full-time equivalent workers for 2009 (the year before Deepwater Horizon) to a comparable rate of 1.6 per 100 million manhours, it appears that offshore work is roughly three times as hazardous as the average of all work. When you consider that the latter reflects the contribution of tens of millions of service and government workers in categories for which highway accidents and homicides account for the largest share of risk, I'm not sure how much lower I'd expect the fatality rate to be for a group of people working long hours aboard facilities jammed with rotating equipment and heavy objects. The subject at least deserves a more thorough look than it was given here.

Then there's recommendation G2, which is the catch-all funding mechanism for all the extra regulatory work required to carry out the commission's other recommendations. I don't disagree that the agencies that monitor and issue permits for offshore drilling should be staffed with enough professionals of suitable experience and training to provide effective oversight and to minimize bottlenecks and delays in the permitting and oversight process. However, the idea that the industry should pay for this with added fees--based on a half-baked analogy to the telecommunications industry--ignores the enormous funding mechanism that's already in place in the form of the lease bonuses, rents and royalties collected by the government from these companies. In the previous fiscal year the agency formerly known as the MMS reported $2.3 billion in revenue from activity on the Outer Continental Shelf, after collecting $9.1 billion the year before. If the federal government has been spending these funds for other purposes, rather than allocating a sufficient portion to protect its investment, there's no guarantee that additional monies collected from the industry would be spent more wisely.

Ultimately, the questions of what happened on the Deepwater Horizon and who bears the blame are likely to be resolved in a court of law. It may be just as well that the commission didn't wait for all the evidence to be in to issue its findings. But they also can't be viewed in isolation. We live in a world in which OPEC seems to be quite content to sit on its ample spare production capacity and watch oil prices ratchet back up towards $100 per barrel and potentially higher, as the global economy recovers. The oil buried under the Gulf represents one our best hedges against OPEC's understandable satisfaction with the status quo. Yes, we need better response capabilities for future spills--some of which is already in the works--and yes, the industry must increase its focus on offshore safety and accident prevention. At the same time, we also need the industry to resume drilling absolutely as quickly as feasible under the new guidelines. The apparent lack of urgency on the part of the commission and administration to make that happen seems divorced from the broader context.

Read More

Not-So-Grand Compromise

This week Senators John Kerry (D-MA) and Joe Lieberman (I-CT) finally released the draft energy and climate bill they had been working on with Senator Lindsey Graham (R-SC.) From all accounts, it was intended to serve as a response to the various criticisms of the climate bill the House of Representatives passed last summer, but in particular as a means for attracting support from Senators whose primary concerns about energy are focused on US energy security and competitiveness. Unfortunately, events have a way of disrupting even the sagest strategies. A cursory review of the new bill--all I've had time for thus far--reveals the degree to which it has been altered in response to the ongoing Gulf Coast oil spill. In the process, unless I've misread its revised provisions on offshore drilling, the expected "grand compromise" has turned into a poisoned chalice, at least for oil.

Like its climate-legislation predecessors and most major bills from the last several Congresses, Kerry-Lieberman (originally Kerry-Graham-Lieberman) starts out at 987 pages and is likely to grow much larger, as it accumulates support one vote--and thus typically one new provision or modification--at a time. I simply haven't had a chance to read the whole thing in detail, yet. Once I've done so, I'll comment on its other key provisions, including the cap & trade mechanism at its heart, which seems to have been influenced by the "cap & dividend" proposal of Senators Cantwell (D-WA) and Collins (R-ME). With so much attention currently directed at offshore drilling, that's where I focused my brief review.

While the bill was being prepared, there was much speculation about the incentives it would include for expanded offshore drilling, which, along with expanded support for new nuclear power, was regarded as one of the principal carrots to be offered to those in Congress who wouldn't otherwise be inclined to support a standalone cap & trade bill. Whatever form those incentives were expected to take, the bill's skimpy offshore drilling "subtitle" looks disappointing, if not downright negative.

On the positive side, it would extend the same royalty-sharing benefits to states pursuing new drilling that the four main Gulf Coast producer states of Texas, Louisiana, Mississippi, and Alabama currently receive from oil & gas exploration and production in the federal waters off their coastlines: 37.5% of lease premiums collected and the same percentage of production royalties. This is something that states such as mine, with an official state policy supporting drilling, have been calling for. But while it will be favorably received in Virginia, other states, particularly in the West and Midwest, regard this as an unreasonable diversion of federal revenue. Even if the Deepwater Horizon hadn't blown up, this provision would have been a tough sell.

The rest of the offshore oil subtitle appears to have been hastily modified in response to the spill. Among other things, it offers states a veto over new drilling within 75 miles of their shores. A glance at the map for the planned Lease Sale 220 offshore Virginia shows that at least a portion of it falls within 75 miles of the Delaware and Maryland coasts. Nor do I think this is an unreasonable provision; as we've seen in the Gulf, a spill off Louisiana clearly affects the shorelines and marine activities of neighboring states. By itself, this provision, which I believe was altered from an original 50 mile exclusion, would not rule out a resumption of new offshore leasing and drilling, once the causes of the current spill have been identified and new measures and regulations put into effect to reduce the risk of another occurrence to an acceptable level--however the Congress and administration might specify "acceptable".

The problem lies in Section 1205, which defines the impact studies that must be done prior to opening up an area for drilling. As drafted, paragraph (h)(2) effectively extends the 75 mile limit on the veto rights of non-drilling states, if the government's assessment "indicates that a State would be significantly impacted by an oil spill resulting from drilling activities within an area identified in a 5-year (leasing) plan". Under this paragraph, Florida or Alabama could potentially veto any new drilling off Texas or Louisiana. I'm not a lawyer, but that's what the text appears to say.

Without dismissing the legitimate concerns of neighboring states, this raises all sorts of practical problems. An exchange I had earlier this week with a Maryland-based blogger highlights one of them. He was blogging in support of Senator Ben Cardin's (D-MD) stance against any offshore drilling on the Atlantic coast. However, as I noted in my comment on his posting, Maryland consumed 272,000 barrels per day of oil in 2008, not one barrel of which was either produced or refined in that state. Just how far should offshore drilling be removed in order to satisfy the concerns of a state that is entirely reliant on energy produced by other states and foreign sources, which must bear whatever risks it entails? Is Louisiana far enough away? Is Saudi Arabia?

As compromises go, this one doesn't look very tempting. Unless I've misread the bill's offshore drilling provisions, it appears that their effective result would be to end all offshore drilling, not just in areas that were recently released from long-standing drilling moratoria, but in the long-established zones of the Gulf Coast that are becoming America's energy breadbasket. That would surely qualify as the kind of overreaction to the Gulf Coast spill of which the International Energy Agency has just warned, emphasizing the unintended consequences that we would risk. Perhaps those looking for something in exchange for supporting limits on greenhouse gas emissions will regard the bill's significant support for nuclear power as sufficient, though I'm skeptical. They could probably get the same thing in an energy-only bill, perhaps in exchange for a national renewable electricity standard. As for the crucial source of domestic transportation energy we would forgo if we turned our back on offshore drilling, there is currently no substitute available soon enough, or in sufficient quantities, to make up for its loss.

Read More

Half Full and Half Empty?

Yesterday's announcement by President Obama that his administration would allow new offshore drilling on selected portions of the Outer Continental Shelf (OCS) that had formerly been off-limits yielded a variety of reactions. Energy industry leaders were cautiously optimistic, environmentalists were disappointed or "outraged", and the Washington Post's print-edition headline called it a "political maneuver." From my perspective, it constitutes a welcome concession to the reality that the day when renewable energy sources can pick up the entire load now carried by fossil fuels is a long way off--decades, not just years--and that until then we still have some important levers to pull in minimizing the amount of foreign oil we must import. Yet however it plays in the Congressional dance to devise a "comprehensive energy bill"--the current terminology for describing legislation regulating greenhouse gas emissions--it clearly falls short of what would be required to put the medium-term energy needs of the country on a truly secure footing.

On the positive side, yesterday's announcement sets the stage for oil producers finally to gain access to offshore acreage that had been off-limits for decades as a result of a combination of Congressional and Executive drilling moratoria. So while it does not strictly speaking open up these areas for drilling--that happened in 2008 when the previous bans expired or were lifted--the President made it clear that he will not reinstate a ban for the Atlantic coast south of New Jersey or for the Chukchi and Beaufort Seas off Alaska. If you are concerned about the energy security of this country and the enormous sums we pay to import oil from abroad, that is good news, even if it will take years to go through the process that Interior Secretary Salazar has outlined.

As usual the traditional media has gauged the potential resources involved with its customary lack of insight into how oil & gas are produced in the real world, comparing them to a few years of total US consumption. The subtext here is clear: how much should we risk for a couple more years' supply of a depleting resource? The reality is quite different. Even at the low end of 39 billion barrels of recoverable oil cited by Secretary Salazar, the new zones could eventually contribute several million bbl/day for a couple of decades. If ramped up quickly enough, that could overcome the underlying decline rate of current US output and add significant net production for a decade or two, at a time when competition for the oil we are currently importing is likely to be fiercest: as the growth of Asia continues and the domestic energy needs of exporting countries skyrocket, but before renewables, conservation and vehicle electrification can achieve their full impact.

Perspective is crucial in situations like this, so let's start with some figures already familiar to my regular readers. If 39-63 billion barrels of oil doesn't sound like much compared to the vast energy appetite of the US, which even in last year's recession-dampened economy consumed 18.7 million bbl/day of oil, or when compared to the enormous reserves of the Middle East, consider that cumulative US oil production stands at around 200 billion barrels from reserves that at no point exceeded 39 billion barrels. If that sounds like a contradiction, it's because the industry has always found more oil and more ways to extract it than expected when the resources were first discovered. There is no reason to believe that won't still hold true, particularly compared to resource estimates based on technology that was current when PCs running on Intel's 286 chip were cutting-edge and cellphones were scarce and looked like bricks.

It's also worth thinking about the prospect of an extra couple of million barrels per day of domestic oil in the context of how much renewable energy we'd have to produce to provide a similar quantity of energy. Wind turbines and solar panels don't even enter into this discussion, because they do not displace any meaningful quantity of oil. That's because they produce electricity, and last year oil accounted for less than 1% of all the electricity generated in the US. On an energy-equivalent basis, each million barrels per day of additional oil production equates to the energy content of 27.9 billion gallons per year of ethanol, or more than 2.5 times last year's record US ethanol production. In terms of useful energy contributed after accounting for the energy used to produce it, that comparison grows to more like 5x: the equivalent benefit of more than 50 billion gallons per year of ethanol, or about half-again the ultimate contribution of the entire 36 billion gallon federal Renewable Fuel Standard. And even if we threw away everything but the gasoline yield from this oil, it would still displace as much imported energy as 40 million plug-in electric vehicles--for which we'd still need to come up with an electricity source.

So if there's so much potential in the areas that the President has offered up for drilling, why would anyone be disappointed or see this as a glass half empty? For starters, it imposes new drilling bans on the entire Pacific Coast and carves out of the eastern Gulf of Mexico some of the most prospective acreage closer to the Florida coast, where large natural gas deposits have already been found. And of course it doesn't even mention the Arctic National Wildlife Refuge, which the USGS estimated to contain another 10 billion barrels, give or take a few billion. Simply put, outside of the Gulf of Mexico more acreage will again be placed off-limits than will be made available for drilling, and even the expansion into the eastern Gulf will require the approval of a Congress that has not looked favorably on drilling there since it placed its own ban on that region in 2006. My disappointment at those limitations is mitigated by the knowledge that drilling there now would be a non-starter, politically. Better to begin where state and local governments are willing and some even eager. Closer to home for me, it appears that Secretary Salazar is postponing the bidding on the Lease Sale 220 area off Virginia that I blogged about a couple weeks ago from 2011 into 2012, holding up lease revenues my state badly needs to plug serious budget gaps. (This would also require Congressional approval of revenue-sharing for these bids and royalties, similar to what the Gulf Coast states currently enjoy.)

In his comments at Andrews Air Force Base President Obama made it clear that additional offshore drilling must be viewed in the context of a broader plan for addressing US energy needs. Yet because of the structure of our energy economy and the enormous relative impact of additional oil production compared to renewables at their current scale, only massive fuel economy improvements and conservation can contribute as much to reducing US oil imports, which even after last year's big drop still averaged 9.7 million bbl/day and cost approximately $210 billion. Opening up more of the OCS, which lies beyond visible range from the nation's shoreline, is a good step forward, and it is one that future administrations of both parties can build on.

Read More

Altered Terms

While I've devoted my last two postings to the climate change aspects of the administration's first budget, some of its other provisions could also have a significant effect on our energy economy--perhaps more, considering their potential impact on a source that still contributes one-third of our total energy diet: domestic oil and gas production. The President's budget seeks to alter many of the financial parameters under which this energy is produced and processed, ultimately affecting the energy prices consumers pay. It's not even clear that these changes would result in a net revenue gain for the federal government, after all their offsetting consequences are tallied.

Let me start by stipulating that the proposed modifications, to the extent they don't breach contractual obligations, are the government's prerogative as the custodian of the public's interest in the resources and activities involved. That's certainly true in the case of oil and gas produced from public lands and the Outer Continental Shelf (OCS). All governments change tax rates and tax benefits periodically, as circumstances change, and businesses shouldn't be surprised or offended by this. (Altering the terms of existing contracts, or enacting punitive taxes to achieve the same result after the courts have upheld companies' legal rights, is a different matter.) What's at issue here is not the government's authority to make these changes, but the wisdom of its doing so, and the ultimate consequences for a nation that still relies on petroleum for 95% of the energy we use in transportation. When it proposes singling this industry out to bar it from taking the manufacturing tax deduction, or ending the expensing of intangible drilling costs, these issues can't just be viewed as isolated line items, without examining their broader implications. In several cases, the changes likely wouldn't even raise overall government revenues.

Consider a provision in the budget to impose a new annual fee on Gulf of Mexico leases not currently producing oil or gas. This is clearly an outgrowth of last summer's spurious "idle leases" debate, which arose from a fundamental misunderstanding of the mechanics of oil and gas leasing and the way that companies determine which prospects to drill first. In any case, the $115 million per year the government hopes to raise with this fee only reflects its direct revenue, without considering the lower bid premiums on new leases that would ensue.

With the exception of the enormously controversial late-1990s leases subject to royalty relief, companies have bid for OCS leases under rules that specify that after paying the bid premium, they must pay rental fees until a property is developed, after which they would owe a 1/6th royalty on any production. (Note that both parties to these contracts have significant incentives for the deals to yield substantial production, and both are harmed when they don't.) The new fee would increase costs for leases that turn out not to have sufficient quantities of hydrocarbons to merit commercial development--over and above the cost of learning that bad news--or that simply never rise to the top of a company's constantly-evolving project list before they expire. Since neither of these outcomes is unusual, the "non-producing lease" fee would become an important consideration in calculating how much to bid in the first place. Net result: decreases in new lease bids would offset the revenue from the new fee, and in the worst case we'd see a significant drop in overall oil & gas "bonus bid", rent and royalty revenue that contributed $23 billion to the federal budget last year. Most of the budget's other energy provisions entail similar risks.

It's not my intention to be naive, here. Other than their employees and stockholders, most people consider oil companies as at best a necessary evil. After another year in which many of these firms turned in more record profits--probably their last for a while--and with few other sectors looking as healthy, they make an inviting target for new taxes and fees. But whether the intention is merely to help stanch the red ink in the budget or to punish these companies for their success when everyone else was hurting, the outcome could be doubly counterproductive, reducing tax revenues by shrinking an activity we already tax pretty thoroughly. It's hard enough for companies to justify maintaining their drilling programs in a period of low energy prices, without making the fiscal terms under which they operate less attractive. How does that align with the administration's goals for energy independence, to which doubling the output of wind, solar and geothermal energy, from 1% to 2% of consumption, can only provide a partial answer?

Read More

Paying Not To Drill

I'm spoiled for choice concerning topics on which to blog , including the first glimpses of the energy provisions of the proposed American Recovery and Reinvestment Act of 2009--better known as the stimulus package--and a rift within the US business community over the best way to set a price on greenhouse gas emissions, between a carbon tax and cap and trade. I'm sure I'll come back to those topics soon, but I must admit the story that most intrigued me this week concerned an event last month, when a young environmentalist disrupted the quarterly oil & gas lease auction of the Utah office of the Bureau of Land Management by successfully bidding on a clutch of leases, the terms of which he at least initially seemed unlikely to be able to fulfill. In the process, he has become a momentary Internet celebrity, with his own website and organization, apparently raising $45,000 with which to make the first payment on the leases and thereby potentially avoid prosecution.

At the outset, let's dispense with all the hyperbole about brave acts of civil disobedience in the cause of saving the planet. Let's also be clear that nothing I say here in any way justifies walking into a duly-authorized auction of a department of the federal government and bidding for mineral leases without the ready means of paying for them. I am not qualified to assess whether Mr. DeChristopher broke the law, but I can certainly relate to the reaction of other bidders when the situation became clear. Nor am I inclined to accept the excuse that the ends justify the means in this case. Having said that, it's hard not to admire the chutzpah that this took, at least a little bit.

According to the article in Monday's Washington Post, Mr. DeChristopher, a.k.a. "Bidder 70" outbid the assembled oil and gas companies on 13 leases totaling 22,000 acres in "the scenic southeast corner of Utah." He bid a total of $1.8 million for these leases, roughly 25% of the total of $7.2 million of winning bonus bids received for the 148,598 acres sold. If he intends to keep these leases, then in addition to coming up with the remainder of the bonuses he bid, he would also need to pay the contractual rental on them, amounting to $33,000 per year for the first five years and $44,000 per year for the balance of the 10-year lease term--not "decades" as the Post's reporter erroneously suggested. $45,000 is a good start, but he and his supporters would have to pony up another $2.1 million over the next decade to keep from defaulting, unless their strategy is merely to tie them up until the new administration halted leasing in the area, as noted in Mr. DeChristopher's letter of January 9 to his supporters.

If we ignore for the moment the part about not having the $1.8 million in hand or in prospect when bidding, this event might actually offer a model by which concerned citizens or groups could preserve onshore or offshore acreage that they prefer not to see drilled, either out of concern for the viewscape or for the environmental consequences of the production and consumption of oil and gas--notwithstanding the implication that it would be produced elsewhere, possibly under less scrupulous conditions. If properly financed, such efforts would be a lot more constructive than tying up the leasing and permitting process in the courts, particularly from the perspective of taxpayers such as myself, who do not share their viewpoint. The outcome might still increase US oil imports, but at least without depriving the government of its income on the leases, although it would forgo the substantial increase in revenue that accrues if oil or gas are found and produced, when modest rental fees are superseded by the 12.5 % royalty rates applicable to such contracts. Oil and gas rents and royalties earned the federal government nearly $13 billion in 2008.

I will be very interested to see how this case turns out, and whether Mr. DeChristopher's idea catches on--with the proviso that there is a crucial difference between backing up one's beliefs with real money and merely gumming up the works at the expense of the rest of us.

Read More

Royalties in Kind

It almost reads like the latest thriller. Just as the Congress is about to consider compromise legislation to expand the portions of the US offshore that are available for oil and gas drilling, and with another major hurricane headed directly for the center of gravity of the nation's energy industry, we learn of a scandal involving government employees responsible for collecting oil & gas royalties. The only element that doesn't fit the plot is that oil prices continue to falter, despite a big decline in US inventories, resulting from most of the production in the Gulf of Mexico having been shut in in preparation for Hurricane Gustav, two weeks ago. I'll reserve my comments on the energy compromise until I see the text of an actual bill, but the MMS scandal demands attention, because of its perceived relevance to the drilling debate.

The subject of oil and gas royalties is not one that ordinarily conjures up images of licentious behavior; it's normally the realm of accountants and auditors. I'm sure millions of Americans are wondering why a group of MMS employees in Denver was even in a position to have been offered lavish entertainment and allegedly to have engaged in conduct unbecoming to a public servant. Historically, most federal royalties were collected in the form of a check, based on the deemed market value at the wellhead of the portion of oil or gas--typically either 1/8th or 1/6th--to which the government was entitled under the terms of a specific production lease. (A notable exception is the late-1990s leases that waived royalties, in order to encourage companies to take the risk of drilling in very deep water, at a time when oil prices had fallen nearly to single digits.) But the problem with verifying the royalty amounts on oil is that the fair market value isn't always obvious, particularly for fields that differ in quality from West Texas Intermediate, or are not accessible by pipeline. The principle behind the Royalty in Kind Program is that if the government takes title to the oil, with volumes verified by a Lease Area Custody Transfer meter, and then sells it itself, there should be no dispute about fair market value.

It is thus ironic that the problems cited by the Inspector General of the Department of the Interior should have arisen from a policy that was designed to reduce the risk of the government receiving less than the full royalty amounts to which it is entitled, for oil and natural gas produced on federal lands or in the federal portions of the offshore. In fact, the Minerals Management Service (MMS) had just reported to Congress that RIK generated $63 million of additional revenue for the Treasury in FY 2007, over and above what it would have collected, had it taken these royalties in cash.

Participating in the oil market to the extent of 190,000 barrels per day, around 4% of total US production, made the MMS a very big player in a segment of the energy business that is highly social. You need to trust the people you do business with, because you must be able to rely on their help when you have a problem, and vice versa. Often, that trust is built by getting to know them over a meal, or at a sporting event. As I've mentioned many times, I traded oil and petroleum products for Texaco on the West Coast during the 1980s and early 1990s. Although I certainly never witnessed or heard of the kind of excesses noted by the Inspector General, I believe that in the absence of a strict organizational and personal code of conduct, the opportunities for someone to go seriously astray in that environment remain significant.

Every year, Texaco's legal department would meet with the company's traders and pipeline schedulers to warn us about conflicts of interest and the requirements of anti-trust law and other regulations. One of our best lawyers would sternly advise us, "Avoid the appearance of evil!" by which he meant, never engage in anything, the legitimacy of which we could not easily explain in a court of law without requiring the benefit of the doubt. Some of the MMS folks and their oil company counterparts might have benefited from such a speech.

My purpose in this posting is not to excuse misbehavior--not a bit of it. However, the stakes in the current energy crisis are too high to permit this incident or the broad generalizations it will spawn to influence the policies that determine how much energy the US will produce for itself in the years ahead, and how much we must continue to import, to the detriment of our trade balance and financial health. The events in question, however distasteful, by no means prove that royalties cannot be collected properly, or that oil companies can't be trusted to deal fairly with the government. All that is required for RIK to work on an arms-length and professional basis is clear and frequently-articulated policies and determined oversight. So by all means, ferret out those responsible, punish anyone who broke the public's trust, and ensure that the Treasury collected what it was due. But exploiting this incident to hold back domestic oil and gas production will cost the US public far more in the long run than any malfeasance that might be uncovered in the MMS.

Read More

Turning Black into Green

For too much of the lengthy debate over expanded access to oil & gas resources, participants on both sides have sought to pit renewable energy against conventional energy. There is nothing at all mutually-exclusive in our need to increase US energy supplies from both of these sources, and an op-ed in today's Washington Post suggests a way explicitly to align them to the ultimate benefit of companies, the country, and of the environment. The concept involved is not new, but it is significant to see it coming from two Congressmen, one a Democrat and the other a Republican. Taken together with the pending "Gang of 10" compromise proposal, it is heartening to see energy beginning to be treated as the enormous bi-partisan challenge it is.

The suggestion of Representatives Marshall (D-GA) and Bartlett (R-MD) looks quite simple, compared to the kind of detailed, more tactical proposals that have been swirling around in the last year or two. It describes a strategic approach to converting the value of oil and gas on federal lands and offshore into the means of funding a large ramp-up in non-fossil energy sources, including renewables and nuclear power. As I understand it, it consists of these steps:

1. Establish a national strategic plan for energy with aggressive but attainable goals for greatly reducing our reliance on fossil fuels in general and imported oil in particular.
2. Utilize the royalty revenue from expanded drilling to fund this transition, rather than sharing it with states or channeling it into the general fund, as is the case for revenue from current leases.
3. Increase the government's share of the market value of this oil and gas by boosting royalty rates.
4. Front-load the investment in alternative energy by issuing government bonds backed and repaid by future royalty revenues from the new leases.

On balance, this is a savvy approach that looks consistent with expanding our supplies of conventional energy over the next decade or two, while positioning alternatives to reduce greenhouse gas emissions in the near-to-medium term and replace fossil fuels in the long term. As with any plan, however, the devil is in the details. In implementing it, we would need to ensure that royalties were not set so high that, after paying them and then paying an effective 40% tax rate on the profits from these operations--plus a future windfall profits tax?--the companies that must invest billions of dollars developing the resources in question could still expect returns attractive enough to merit taking on the enormous risks inherent in these very complex projects.

The current federal royalty rate on leases in the Outer Continental Shelf of the Gulf of Mexico takes a flat 16.7% of the oil and gas revenue at the wellhead, in value or "in-kind". If the government's mean estimate of 18 billion barrels of untapped oil under federal waters proves correct, then at current oil prices the clean energy fund proposed in the op-ed would stand to capture as much as $330 billion over the producing life of these fields. Even if only a tenth of this resource could actually be developed, consistent with the pessimistic forecasts adopted by drilling opponents, that is still a sizable sum to invest in clean energy today.

Messrs. Bartlett and Marshall would also like to see royalty rates rise further, though part of their justification for that appears to rest on the flawed assumption that current royalty rates provide such lavish returns that companies are encouraged to slow development to defer their earnings. What is needed, I suspect, is royalty reform, not just higher royalty rates. Royalties ought to take into account the entire applicable tax regime on oil & gas producers. It seems reasonable for the government's share of oil revenue to rise when prices are high and fall when prices decline. Otherwise, we risk either seeing production shut in at prices at which it should still be economical, or blocking development entirely. Royalty structures must also contemplate all possible future price scenarios, not just current prices; that is the clear lesson of the royalty-relief debacle of a few years ago. Higher royalties will inevitably reduce lease bids, so that trade-off must be incorporated, as well. This is the sort of problem that seems well-suited to a bi-partisan commission to resolve.

The spirit of energy compromise is in the air, perhaps just for this brief interval before the November election. Representatives Marshall and Bartlett's plan deserves serious attention, either as part of the Gang of 10 initiative or separately. While I might dispute their assertion that we have benefited from locking away the contested resources for a generation, I certainly concur that tapping them now is timely, coinciding as it would with reduced US energy demand growth. Any effective plan for achieving our collective vision of greater US energy security must ultimately reduce to the simplicity of using less while producing more, ourselves. Capitalizing on our remaining "black gold" to grow more green energy--while also generating more of the other kind of green to reduce our trade and fiscal deficits--looks very smart, indeed.

Read More