The Back Door on CO2

When the Supreme Court ruled in Massachusetts v. Environmental Protection Agency that carbon dioxide was a pollutant, the implications were clear. Rather than waiting for the Congress and President to agree on federal climate change policy, presumably built around an economy-wide cap & trade system or a carbon tax, the Court told the EPA that it had all the authority it needed under the Clean Air Act to order emitters of greenhouse gases to cut back--regardless of the wider repercussions. Now a lawsuit filed by the Attorneys General of New York and eleven other states seeks to force the EPA to implement this ruling on emissions from US oil refineries. But unlike a comprehensive approach, such a selective effort would greatly worsen the nation's energy security, while having very little impact on overall US greenhouse gas emissions.

The US emitted a net 6.2 billion tons of CO2-equivalent greenhouse gases (GHG) last year. Reducing those emissions has become a high priority, and pending a federal response along the lines of the Boxer-Lieberman-Warner cap & trade legislation that failed to pass the Congress earlier this year, the states have largely taken the lead. New York's suit to force the EPA to implement the High Court's ruling on CO2 as a pollutant is just one example of this trend. But in singling out oil refining, the states have chosen a target with enormous negative leverage on US imports of petroleum products--and thus on US energy security. Moreover, oil refining contributes a very small share of total US GHG emissions. California, which joined New York in filing this suit, is home to nearly 12% of US refining capacity, but its refineries account for only about 3% of the state's emissions, despite processing some of the nation's most challenging crude oil. 3% is small beer, compared to the 39% of US emissions attributable to electricity generation, or the 30% associated with our use of all transportation fuels. (Input from a chemist at the Air Resources Board suggests that refinery emissions may be closer to 7% of the state's total, although that includes co-generated electricity, some of which is sold.)

To appreciate why the cost/benefit ratio of this effort is so poor, you have to understand where GHG emissions occur along the petroleum value chain. End use, not processing, is the biggest source by a long shot. With their raw material priced over $100/bbl, and their other main energy input, natural gas, costing about half that on a barrel-equivalent basis, refiners have ample incentives to be efficient. Every BTU they burn in the course of making gasoline, diesel, jet fuel and other products is a BTU they can't sell. The latest analysis by Argonne National Laboratory found that the average oil refinery operates at 88% efficiency. Since emissions follow energy use, that means that while burning a gallon of gasoline in your car releases 19.4 lb. of CO2, only 2.6 lb. were emitted refining it. Reducing refinery CO2 emissions by 20% would have no more impact on climate than improving the fuel efficiency of the average car by 0.5 miles per gallon--less, in fact, because the US already imports a million barrels per day of gasoline and gasoline blending components. And there's the rub.

Because CO2 emissions from refineries are tied directly to their energy consumption, the only way refiners have to reduce those emissions is to process less oil, or to process it less intensively. Either option reduces their output of the high-quality transportation fuels the US demands--think reformulated gasoline and ultra-low-sulfur diesel--and forces us to import more of them from overseas, from refineries that won't be subject to the EPA's regulations on emissions. Sure, refiners can buy some renewable electricity, but that won't produce any net GHG reductions for the economy. With most US electricity still generated from fossil fuels, they would just compete with whoever is buying that output today, and drive up the premium on green electrons. And with the economics of wind and solar power still depending more on incentives than on the price of electricity, it would be hard to argue this would lead to additional renewable electricity capacity being built.

No one expects the refining industry to be handed a Get Out of Jail Free card on its greenhouse gas emissions. However, singling out refineries for enforcement of air-pollution-style regulations on their emissions will yield minimal net CO2 reductions and merely shift its emissions offshore, while further eroding the employment and profits of this strategic manufacturing sector. In addition, increasing US imports of refined product would worsen our trade deficit by their margin over crude oil. In the case of diesel fuel, which is in short supply globally, that has averaged $22 per barrel so far this year. The suit by New York, California, and the other states thus reflects a poor grasp of both energy economics and environmental priorities. If we want to reduce the GHG emissions from our use of petroleum, we must focus on squeezing demand for it, not the US companies that process it into fuels.

By the way, The Economist is hosting an interesting debate on whether existing technologies are sufficient to solve our energy problems.

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Pay-Go for Renewable Energy Credits

While Congress and the Presidential candidates are busily debating far-reaching energy proposals, the existing tax credits for wind and solar power and other renewable energy are still slated to expire at the end of the year. The uncertainty about their continuation is apparently beginning to slow down new installations and may be putting some of those vaunted "green collar" jobs at risk, at least temporarily. Although a broad consensus supports their renewal, the hang-up is over funding. I'd like to offer an alternative that at least makes policy sense, if not political sense. Its appeal will be limited by the reticence of both sides of this debate to be seen explicitly raising the price Americans pay for energy.

I've lost count of the number of times the Senate has missed extending the Renewable Electricity Production Tax Credit (PTC) and the Solar Investment Tax Credit (ITC) this year. Six? Seven? One of the latest such efforts was S.3335, the "Jobs, Energy, Families, and Disaster Relief Act of 2008". Voting against something with that title must have felt like voting against motherhood and apple pie, although the bill should more accurately have been designated the "Renewable Energy and Comprehensive Pork Act of 2008," including as it did such diverse provisions as a "Seven Year Cost Recovery Period for Motorsports Racing Track Facility," "Provisions Related to Film and Television Productions," and my favorite, the "Modification of Rate of Excise Tax on Certain Wooden Arrows Designed for Use by Children." I wish I were making this up. Having previously failed to satisfy the requirement for revenue neutrality, also known as "Pay-Go", by singling out the oil & gas industry for loss of a manufacturing tax credit--an idea resurrected in the proposed "Gang of 10 Compromise"--the revenue provisions of this bill focused on tax changes on deferred income and securities transactions.

All of this seems unnecessarily convoluted. If the Congress wishes to adhere to the principal of revenue neutrality with regard to incentives for renewable energy, the most sensible place to seek funding is one that also encourages energy demand reduction, to complement the PTC's and ITC's supply and efficiency contributions: a tax on the forms of energy these renewables are intended to displace. Contrary to a widely-held misunderstanding, oil accounts for less than 2% of the US electricity supply, so wind , solar, and other forms of renewable electricity displace virtually no petroleum. But even as Americans are driving less and consuming less gasoline, thanks to high fuel prices, electricity demand continues to grow steadily. From April 2007 through March 2008, US electricity demand was running 2% ahead of the previous 12 month period, on a par with its five-year average growth rate of 1.6%. Considering that last year 72% of our power was generated from the combustion of fossil fuels, taxing electricity consumption to pay for the extension of the PTC and ITC would reduce both demand and emissions, while hastening our widely-desired conversion to renewable energy sources.

I've seen a wide range of estimates of the cost of renewing the PTC and ITC. At last year's installation rate for wind power alone, extending the PTC indefinitely would add roughly $300 million each year to the federal deficit, compounded. That aggregates to about $17 billion in lost federal tax revenue over 10 years. A tax of 0.1 ¢/kWh on sales of fossil-fuel-generated electricity would raise more than $25 billion over that period, while increasing the average consumer's monthly bill by only about $1 per month. If we're looking for "Pay-Go" that aligns policy with purpose, that seems like a much better candidate than taxing other forms of energy production and potentially leaving us even less energy-secure than we were.

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Defining Speculation

Oil market speculation is back in the news, because Vitol S.A., one of the world's largest oil-trading firms, has apparently been re-classified as a "non-commercial" market participant by the Commodity Futures Trading Commission (CFTC). That marks them as a speculator, this year's scarlet letter. Before we pass judgment on the influence of such firms on the price of oil, and thus on the petroleum products consumers buy, it's worth considering what we really mean by speculation, and how this might be distinct from the activities of the participants that the CFTC deems "commercial", i.e. those conducting futures, options and swap transactions in conjunction with their physical production or consumption of various forms of energy. More importantly, we should evaluate whether speculation is an important enough factor in the oil market to merit distracting us from the urgent pursuit of solutions that would expand energy supplies and shrink demand.

As big as they are, Vitol hardly fits the profile of the kind of speculators that stand accused of driving up the price of oil and everything connected to it to unprecedented levels. Vitol has been trading oil since the 1960s, and I did my first deal with them in the 1980s, when I traded petroleum products for Texaco's West Coast refining and marketing subsidiary. I got a much better sense for just how large a player they were in the physical markets for oil, feedstocks and refined products when I traded international products in London in 1989-91. There were few markets in which Vitol didn't participate, and a few niches that they dominated. Although I haven't had any contact with them in at least 14 years, their growth during that interval has been impressive. So I was hardly shocked to learn that they had apparently accounted for a significant fraction of the open interest in crude oil on the New York Mercantile Exchange (NYMEX) earlier this year. Any non-producer transacting the volumes of physical oil and products deals they do could not manage their business properly without extensive use of futures, options and over-the-counter swaps, little of which could fairly be called speculation.

Texaco's trading division had very firm rules about speculation on futures or options, which it defined as long or short positions that weren't directly linked to a like quantity of physical oil or products we were buying, selling, or holding in inventory, contemporaneously. Even for a group focused on "wet" cargoes--actual liquids on ships, barges, or in pipelines--that was sometimes limiting, because it meant we had to do the physical transaction first, and then scramble to hedge it. But while we couldn't take "naked" long or short positions in the market, we could transact "spreads" that were basically bets on some aspect of the market, such as a widening or narrowing of the price difference between futures contract months, or between different products, or different locations. While we weren't speculating on the absolute price, risking large swings in profit and loss, we were certainly risking smaller amounts on these other market attributes. I think most people would consider that speculation, since we didn't have to do it to support our physical trading or the company's much larger producing and refining businesses. But aside from some modest, inconsistent profits it gave us insights into market trends that passive observers don't usually gain: if you really want to understand a market, you have to be in the market.

Now consider Vitol, buying and selling oil and product cargoes all over the world and owning interests in oil terminals on three continents, a few oil fields, and a small refinery in the Persian Gulf. That doesn't put them in the same league as ExxonMobil--which, unless things have changed a great deal since the Exxon-Mobil merger in 1999, doesn't trade on the NYMEX at all--or legitimize every position they take as non-speculative. However, it's a far cry from the stereotypical view of asset-class commodity speculation by pension funds and hedge funds, executed by twenty-somethings who wouldn't know an octane from an antelope. That's important, because long-established oil trading firms like Vitol have institutional memories that span many up and down cycles of the oil market and know that a trend can turn when you least expect it. It doesn't mean they wouldn't risk a big loss to make a big profit, but in my estimation it makes them poor candidates to be the driving force behind a wave of speculation perceived to have pushed the price of oil beyond the level that could be explained by the fundamentals alone.

The roughly 20% drop in oil prices since the beginning of July should calibrate our estimates of the influence of such speculation. It was clearly not sufficient to maintain momentum in the face of weakening fundamentals of demand, supply and risk. At the same time, our response ought to distinguish between the kind of speculation represented by oil market neophytes hoping to cash in on an attractive investment trend, and the speculation that is an absolute requirement of a smoothly-functioning commodities market. Anyone who thinks the oil market would work just fine with only producers, refiners and end-users has never spent a day trading, or seen liquidity vanish just when a specific transaction was most desirable or necessary, because there was no middleman willing to take it on as a bet. But regardless of whether one variety of speculation should concern us more than another, the market's dramatic response to sliding demand serves notice to policy makers that their best and most productive avenue for addressing the impact of high oil prices is surely prompt and meaningful action on supply and demand, rather than rounding up today's version of the usual suspects.

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The Persistence of Change

Weakening demand appears to be the main oil market driver these days, with the US having just tallied its 12th consecutive monthly decline in gasoline demand, year-on-year. For the moment, at least, good old supply and demand have displaced imminent Peak Oil and a perceived commodity bubble as the dominant narrative. If we needed further evidence of that, the market's collective yawn at Russia's threat to the Caspian pipelines passing through Georgia ought to serve nicely. But how much of the recent decline in consumption is attributable to the price elasticity of demand, and how much to the weakening US economy? The answer is of more than passing interest, signifying whether we're likely to see a bounce in demand once the pump price catches up with the 20% decline in the price of West Texas Intermediate crude oil since the 4th of July.

The US average retail gasoline price has fallen for six weeks and currently stands at $3.74 per gallon. Barring an unexpected oil-price rally or a major refining problem, unleaded regular prices beginning with a "4" should soon disappear at all but the most expensive stations, even in California. Perhaps this is just a case of the August doldrums, but the price of oil is currently stuck in a range that defies the principal explanations for its behavior earlier this year. With the market clearly responding to fundamentals, its path from here will depend heavily on whether consumers continue to drive less, and that depends on the relative importance of the psychological impact of $4 gasoline, compared to a broad range of economic factors including falling home prices, tightening credit and surging inflation--some of which is attributable to high fuel prices.

The last stretch in which US gasoline demand declined for 12 consecutive months occurred in 1990-91, a period that also coincided with a spike in fuel prices--thanks to Saddam Hussein--and a recession. The Gulf Coast hurricanes of 2005, which gave the country its first taste of $3 gasoline, caused only a brief drop in demand. Within 3 months of Katrina's landfall monthly US gasoline demand had resumed its year-on-year growth, consistent with the robust economic growth (helped by the housing bubble) that we were experiencing at the time. Nor did the recession of 2000-2001 prevent gasoline demand from growing by 1.6%, with only a few months exhibiting declines versus the same month of the previous year. Of course, gasoline was well under $2 at the time.

It seems to require an unusual combination of low growth and high prices to overcome the inherent gasoline demand trend of the US economy and shock consumers into conservation mode. Since the economy seems unlikely to recover soon, the persistence of the recent changes in consumer behavior concerning fuel consumption and new car selection thus hinges on just how cheap $3.50 gas will seem to America's drivers after a couple of months over $4.00 per gallon. In the absence of more dramatic events, this could also determine the price of oil on Election Day, a parameter that could influence that contest's outcome.

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The Drilling vs. Alternatives Contradiction

F. Scott Fitzgerald once said, "The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function." By that measure, the present debate over energy policy in the Congress looks truly impressive, incorporating a number of such "opposed ideas." A prime example is the arguments against expanded domestic oil and gas drilling, many of which look equally applicable to increasing our production of ethanol from grain. In particular, if expanded drilling can be dismissed as not worth the effort or associated trade-offs, based on a curiously-low DOE projection of future production from US oil resources currently off-limits to drilling, then the US grain ethanol program should be subject to the same criterion. However, in the absence of any single, all-encompassing solution to our energy problems, can we afford to reject any of these options, or worse yet, to pit them against each other as though they were somehow mutually exclusive? We need fewer such contradictions, if we are to make real progress in reducing our geostrategic and financial exposure to oil imports.

Start with the energy contribution of that off-limits oil. I find it extraordinary that the DOE's estimate of 200,000 barrels per day from this resource has been so widely accepted without question--mainly by those, the extent of whose expertise concerning oil generally begins and ends with the business end of a gasoline dispenser. But set aside for a moment the apparent disconnect with the government's own estimate of 18 billion barrels of oil resource in the off-limits portions of the US offshore, a quantity a dozen times larger than the DOE's forecasted cumulative yield from these resources over 20 years. Let's stipulate that paltry-sounding 200,000 bbl/day and convert it into BTUs. It works out to roughly 0.4 quadrillion BTUs/year (quads), or 0.4% of our annual energy consumption, coincidentally about the same quantity of energy we currently get from wind power, based on the natural gas it displaces. Now translate that energy content into its equivalent in ethanol, and you get a figure of 5.2 billion gallons per year, equal to the entire increase in ethanol output mandated between 2007 and 2010--a mandate that was just upheld by the EPA against an appeal from the Governor of Texas. But if it is not worth increasing domestic oil production by the equivalent of 5 billion gallons per year of ethanol, creating US employment and providing the federal government with significant royalty and tax revenues, while displacing $8 billion per year in energy imports at current prices, then what possible rationale can there be for mandating and subsidizing an increase in our ethanol output by a like amount and risking its uncertain impact on the price of grains and other foods?

But wait, you say, ethanol is renewable and good for the environment, while oil is a depleting resource and bad for the environment. The grain of truth in this argument is more than offset by the significant environmental costs associated with corn ethanol production, including high water consumption, fertilizer runoff that contributes to a growing Dead Zone in the Gulf Coast, and greenhouse gas emissions that may actually exceed those of oil, when the global impact on land use for agriculture is considered. Nor is the depletion argument very compelling. After all, it's not as though the opponents of drilling intend to save our untapped offshore oil for future generations, who they probably hope will be even more averse to drilling, and who may lack a domestic oil industry capable of undertaking such a project, in any case.

Long-time readers of this blog know that I am not exactly enamored with our current policy towards biofuels produced from foodstuffs, and particularly with the manner in which subsidies for them are handed out. Ethanol is no panacea, and it consumes vast quantities of natural gas, pushing up the latter's imports and price in the process, but at least it displaces much more oil than it consumes and makes a useful contribution to reducing our oil imports. The severity of this energy crisis requires that we pursue every such source we can, including new supplies of conventional and alternative energy, along with the savings from improved efficiency. If it is necessary to hold our noses to the extent of accepting that we need conventional ethanol in our energy mix, at least for now, and that we must have tens of thousands of wind turbines--which some consider a blot on the landscape--then the same logic ought to apply to exploiting the domestic oil resources to which we have restricted access for reasons that have been superseded by events. Loving renewables and hating domestic oil is a contradiction that only benefits OPEC and America's economic competitors.

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Oil in the Crosshairs

For the last several years, the oil market has focused on the risk of a new conflict in the Persian Gulf, evolving from earlier fears of a direct US/Iranian confrontation to recent worries that Israel might attack Iran's nuclear program. I suspect that little of that oft-cited "risk premium" was devoted to the chances of a shooting war breaking out in the Caucasus, virtually on top of a key oil export route from the Caspian Sea. Yet here we are, with Russia intervening Friday on behalf of one of Georgia's breakaway regions, South Ossetia, and bombs apparently falling near the Baku-Tblisi-Ceyhan Pipeline (BTC) that carries oil to the Mediterranean from the giant "ACG" oilfields of Azerbaijan. If the pipeline, which suffered an unrelated fire last week, were forced to shut down for an extended period, about 1% of the world's oil production could go off line, at least until some portion of it could be re-routed. The market shrugged off this prospect initially, with WTI falling $5 to end last week at $115. I would be surprised if the reaction this week proved quite so blasé.

Georgia was occupied by Russia for nearly 200 years prior to the collapse of the USSR, and the Caucasus is at least as strategic today as it was in the time of the czars, considering its role in the transit of the hydrocarbon resources of the Caspian Sea region. Prime Minister Putin, who appears to be calling the shots in this matter, likely regards Georgia as a rightful part of Russia's sphere of influence, but that doesn't give us many clues about the true extent of Russia's war aims. Given the preparations apparent in the current offensive, these could extend to annexation of South Ossetia into the Russian Federation, regime change in Tblisi, or merely putting a good scare into any former Soviet territories flirting with the idea of NATO membership. Although Russia was hardly pleased with the selection of an export route for Caspian oil that deliberately avoided its territory and control, and has gone to great lengths to regain state control over its own oil industry, oil isn't necessary to explain the events in Georgia.

Unfortunately, the implications for oil supplies go beyond the immediate disruption of the roughly 800,000 bbl/day the BTC line was carrying prior to last week's accident. In its latest Oil Market Report, the International Energy Agency cited expected additions to Azeri production of 200,000 bbl/day this year and a like quantity in 2009. As tightly balanced as the oil market remains, with demand destruction largely responsible for the current slump in prices, it would be bad news if those extra supplies could not be accommodated via the BTC or other export routes. Even if the Caspian hasn't quite delivered the oil gusher some expected a decade ago, it is one of a small number of regions in which production trends have been going the right way.

Whoever threw the first punch--and so far neither side seems terribly credible concerning this--the timing of the conflict favors Russia's attaining its goals in this affair. The combination of high energy prices and a highly-distracted America shrinks the odds that either the US or EU will take on Russia in defense of a former Soviet republic, beyond issuing statements asking Mr. Putin to respect Georgia's territorial integrity. Even if the BTC pipeline survives unscathed and quickly resumes deliveries, political risk in the entire region has increased, and future development from this crucial non-OPEC source could slow. That would keep oil prices higher, for longer than otherwise. With roughly $300 billion per year in oil export revenues at current prices, Russia sits near the top of the list of beneficiaries from such an outcome.

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Alternative Energy for Shipping

Last Sunday's New York Times carried an interesting article on the implications of high energy prices for the sustained globalization of supply chains. The reporter described how rising shipping costs were forcing manufacturers and retailers to rethink fundamental aspects of their business models, ultimately threatening the continuing expansion of world trade. Higher oil prices are responsible for much of the rise in freight rates, particularly for products carried by sea and air. Marine and aviation fuels are taxed very lightly, so they are more sensitive to changes in oil prices than motor fuels. But while airlines are hoping--perhaps in vain--for long-term fuel price relief from biofuels, cargo ship operators are likely to experience more competition from other uses for bunker fuel, and may need to seek solutions involving more exotic energy sources.

Earlier this year, I mentioned an idea for deploying small, high-tech sails to reduce the fuel consumption of cargo ships. But if world oil supplies fall seriously short of meeting potential demand in the years ahead--an easy prospect to imagine, given the rate at which Chinese and Indian consumers are buying automobiles--ocean freight lines may need to look elsewhere for their primary energy source, not just for ways to supplement it. In 2004, the residual fuel burned by ships and power plants accounted for 1 out of every 8 barrels of global oil demand. If competition for crude oil increases, refiners may be more interested in turning the long, complex molecules in fuel oil into higher-value products such as diesel and jet fuel, rather than selling them as-is. Thanks to heavy investment in upgrading hardware, US refineries produce less than a quarter of the "resid" volumes they did in the late 1970s, and their scope for further "resid destruction" is limited. Globally, however, upgrading 10 million barrels per day of resid output could ultimately prove more attractive than producing the same quantity of hydrocarbons from oil sands, shale, or coal-to-liquids. Where would that leave the shipping industry?

Two large-scale alternatives come to mind, assuming that biofuels will remain focused on the highest-value fuels segments, substituting for gasoline, diesel and jet fuel. Between the late 1970s and early 1990s, nuclear power and coal displaced most petroleum liquids from the US power generation sector. Either could provide a long-term substitute for residual fuel in ocean-going vessels. Nuclear power has obvious advantages in terms of its low emissions and extensive experience in naval fleets, plus a few civilian icebreakers. Unfortunately, the disadvantages will appear equally obvious to nuclear critics, in terms of the risks of proliferation and terrorism, which at sea may be less manageable than onshore. However, if it proved cost-effective, this is one way that nuclear power could directly displace more oil, and it might be achieved faster than we could build a new generation of land-based nuclear power plants.

A return to coal for ships' fuel might seem an odd and untimely suggestion, in light of concerns about greenhouse gases and the other emissions from burning coal. However, if this were done using small onboard gasification units fueling efficient gas turbines, rather than coal-fired boilers, the CO2 output from such a system might be no worse than from today's ships. And with the right equipment, sulfate and nitrate emissions that contribute significantly to urban air pollution in busy ports could also be scrubbed, at least for limited durations. The practicality of such an approach would have to be demonstrated, but the underlying driving force is clear. Despite the recent spike in coal prices, the BTUs in thermal coal still cost less than half as much as those in bunker fuel, at current prices.

A global retrenchment in trade due to the impact of high energy costs on freight rates would affect shipowners as much as their customers. A generation ago, the world's cargo fleets converted from steam turbines burning the lowest-quality bunker fuel available to the powerful, reliable marine diesel engines that dominate today's commercial shipping. The cost of operating these engines--and thus global shipping rates--depends on the price of the heavy fuel oils they consume. Although shipping firms lack a practical alternative fuel today, there's no reason the next generation of ships couldn't be built around entirely different energy sources. That would be on a par with the shift from coal to oil early last century, and far less dramatic than the switch from sail to steam.

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