It's Time to Let Virginia Drill

At last Thursday's Summit on Virginia's Energy Future in Richmond, Governor Robert McDonnell delivered a detailed talk on the state's energy opportunities and the bi-partisan commitment of the legislature and Virginia's US Senators and Congressional delegation to capitalize on them, including its offshore oil, gas and wind resources. He also declared his goal of making Virginia the "energy capital of the East Coast." While neither Virginia nor any of its neighbors up and down the coast seems likely to compete with Texas or Louisiana in total energy production, the new Governor's aspiration might be more than just wishful thinking. However, as the business and governmental leaders who spoke at the session made clear, Virginia doesn't control its own destiny in this regard. The Commonwealth's plans for tapping the value of those resources to help close its budget deficit depend on the cooperation of the US Department of the Interior (DOI), which controls the leasing and permitting process for exploration and development on the Outer Continental Shelf (OCS).

Attending the summit provided me with a much better appreciation of my state's energy situation. When we moved our family here nearly four years ago, I confess I didn't spend a lot of time thinking about local energy issues, beyond confirming that electricity was cheaper and likely to be more reliable than where we had lived in Connecticut. Although Virginia produces essentially no crude oil, it does have respectable quantities of natural gas and coal, a bit of hydro and biomass power, and is home to two nuclear power plants, each with two reactors. Unfortunately, like many states, Virginia's own energy production isn't sufficient to meet our needs, and we must import significant quantities of power, along with 100% of our petroleum supplies, either as crude oil for the single small refinery at Yorktown, or as finished products. Several speakers mentioned that the Commonwealth is second only to California in state electricity imports.

Also like many other states, Virginia faces a significant budget shortfall as a result of lower tax receipts, mainly due to unemployment that, while lower than the national average, is still well above pre-2008 levels. A consistent theme from the participants at the summit was that although Virginia's offshore energy resources don't appear to be large enough to make it energy independent, a share of the bid premiums, rentals, and royalties similar to that received by Texas, Louisiana, Mississippi and Alabama for their OCS resources under the GOMESA law of 2006 would be very useful in addressing state funding shortfalls, particularly for transportation. Together with the job creation and non-royalty tax revenue that would accompany development, the offshore resources constitute a very attractive economic proposition.

Estimates of potential resources included in Virginia's first lease area are around 130 million barrels of oil and 1.1 trillion cubic feet of gas. That's a lot smaller than the kind of deposits that have been found in the deepwater Gulf of Mexico, though as several speakers pointed out these figures are based on outdated technology and would likely increase significantly with current techniques. That's important because when the surveys underlying these estimates were done, the state of the art most likely wouldn't have found any of the big plays now being exploited in the Gulf or off the coast of Brazil. And even if any resources discovered were closer to the DOI's current estimate than the 800 or 900 million barrel upside potential that a couple of Thursday's panelists mentioned, it could still create a valuable stream of royalties and taxes for a medium-sized state. In addition to its oil & gas potential, coastal Virginia also has an excellent wind resource in the Class 5/Class 6 category desirable for offshore wind farms, with several firms indicating interest.

Having passed legislation declaring the Commonwealth's support for offshore development, along with a bill allocating resulting government revenues to transportation funding and renewable energy R&D, Virginia is, as the Governor put it, "ready to go." Under the previous US administration DOI included Sale 220 for Virginia's OCS in the 2007-2012 leasing program of the Minerals Management Service. That put Virginia in the first lease round for the Atlantic and Pacific coastal regions that had previously been subject to the expired offshore drilling moratoria. The sale was expected to occur in 2011. With appropriate revenue sharing in place, Virginia wouldn't have to wait for production to begin in five or more years, but could begin receiving bid premium and rental income as soon as the sale is held. Unfortunately, the current management of DOI has not exhibited much enthusiasm for advancing these plans. Virginia officials, including the Governor and our two US Senators, have contacted Secretary Salazar to convey the urgency of proceeding with the sale.

As I've noted on many occasions, the US still has significant undeveloped oil resources, and we're likely to need every barrel they can contribute in the years ahead as global demand grows. The Congressional and Presidential drilling moratoria that formerly blocked development on two of our coasts no longer apply, and it is in the financial and energy security interests of the nation to move ahead with development where the affected states support it. The clear message last Thursday was that it is now the official policy of the Commonwealth of Virginia to develop its offshore resources. By leasing Virginia's OCS oil and gas, DOI would turn the President's comments in support of offshore drilling in this year's State of the Union address into concrete action. That would produce immediate and long-term economic benefits for the state and local communities, while providing badly-needed revenue for the federal government. After decades of delay, there is no better time than now to move ahead with this.

FYI, I'll be traveling on business this week. Postings will likely resume Friday.

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Putting a Price on Risk

I spent most of the day in Richmond yesterday attending the first Summit on Virginia's Energy Future. I'll write more about the main topic of that session next week, but a statistic from one of the panelists stuck in my mind for the entire drive home. In describing the risks that utilities take on when investing in new power plants, the President and Chief Nuclear Officer of Dominion Virginia Power, David Heacock, explained that over the sixty year life of such a facility, the cumulative difference between their high and low long-term natural gas price forecasts amounted to $7 billion, equivalent to the entire up-front cost of a nuclear power plant. He also suggested that the value of the difference between their high and low forecasts for the price likely to be imposed on CO2 emissions was in the same ballpark. Despite the recent financial crisis and accompanying loss of confidence in sophisticated risk-monetizing mechanisms that failed so spectacularly to account for low-probability events, some businesses have no choice but to assess risk in terms of its dollar impact. And as government fills in for a number of hopefully-temporary gaps in various markets, it must also grapple with risk in this way.

The President's proposal to quadruple the total loan guarantees available for new nuclear power plants has raised some concerns about the cost of backing loans to an industry that has suffered spectacular defaults in the past. Doubtless many of my readers are too young to remember the WPPSS (or "Whoops") default in the early 1980s. The amount in question, $2.25 billion, would seem more like a rounding error in today's inflated terms, but that was a lot of money at the time, and it caused quite a stir. I don't believe the Whoops precedent is relevant to today's emerging nuclear renaissance, other than as a reminder--as if we needed one after the last couple of years--that the risk of default is never zero, and a loan guarantee always costs something.

I also find it interesting that worries about the cost of such guarantees have come up mainly in the context of nuclear power, while loan guarantees, loans and outright grants to a variety of "green" projects and firms have attracted little comment along these lines. A case in point is the widely-celebrated $529 million federal loan--that's loan, not loan guarantee--to Fisker Automotive. As with today's nukes vs. Whoops, there may be no direct analogies to the DeLorean experience or various other sorry episodes in the history of the car business, other than to remind us that the risk of default on that loan is also not zero.

As another speaker at yesterday's session pointed out, we are in an extraordinary time, in the aftermath of a financial crisis and with credit for many firms still frozen. At such times, the government may have to step into roles that are otherwise better left to the private sector, such as financing auto start-ups and backstopping loans to power plants. When that happens, our proper attitude towards the risk that we are taking on collectively is neither to sweep it under the carpet, as has largely been done with various green loans and loan guarantees, nor to assume it approaches 100%, as some seem to be doing in the case of nuclear power. The magnitude of these risks can be quantified and weighed against the cost of doing nothing. It can also potentially be reduced through judicious diversification--recognizing that the government itself controls some of the key risks of default through another of its powers, to regulate. With great power comes great responsibility, and those wielding it today should consider that carefully, as they would be called to account later should some recipient of one of these loans or loan guarantees ever default. Now, that's a 100% certainty.

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Who's Ahead?

A couple of months ago I conceded that I was probably overly optimistic when I periodically pointed out that our problems fell short of reprising the 1970s. While I haven't heard anyone describe our current condition as "malaise", there does seem to be little optimism in the US these days. Perhaps one reflection of the country's sour mood is the growing fashionability of proclaiming that we are falling behind in the race to develop renewable energy or clean technology, as the Secretary of Energy apparently did in a speech on Monday. Yet when I looked at several of the examples he cited, it was not at all clear that we are lagging. Much depends on how we define the competition, and I would respectfully suggest that doing that in a way that makes our situation look worse than it is might just reinforce a sense of inevitable failure and decline, rather than galvanizing us to collective action, as I'm sure Dr. Chu intended.

One of Dr. Chu's comparisons concerned China's goal to generate 10% of its electricity from renewable sources this year and 15% by 2020. That's a positive turn, considering that country's reliance on coal. However, the US has already reached that milestone, according to the figures compiled by the Energy Information Agency, a unit of the DOE. We got 10.4% of our power in 2009 from renewables, through November. I suspect it's only possible to see us as falling behind on this metric if you focus exclusively on the contribution of wind, solar and geothermal power, which together accounted for 2.2% of US net generation last year, and then compare that to China's 10% target--ignoring the 6.9% contribution of conventional hydropower here. I am fairly certain that China's government wouldn't make such an exclusion, and that they will count everything they can reasonably characterize as renewable in assessing their progress toward their goal. Of course China is still building hydropower dams, rather than dismantling them, so their inclusion might be less controversial, there.

Then there's nuclear power, another area in which Dr. Chu suggested we were falling behind. Certainly if the comparison hinges on momentum, there's no question that other countries have been building new nuclear power plants at a much faster rate, while the US has added only a handful of facilities since the 1980s. Until quite recently, building new reactors here looked politically and economically infeasible, and US nuclear operators focused instead on getting the most out of the plants they had. (It's an impressive story, by the way.) Nevertheless, although we're often quick to point to France as the world's nuclear power leader, US reactors outnumber French ones by 104 to 58, and both countries have exactly one new plant currently under construction, counting the Watts Bar-2 facility in Tennessee that would probably only get noticed by the national media if it had a problem more newsworthy than the layoffs associated with the end of the project's design phase. Even once China completes the 57 reactors it apparently has planned or under construction and passes France, the US will still lead the world in this category. New reactors now under consideration would extend that lead farther.

My purpose in pointing out these misperceptions isn't to pick on Dr. Chu, engage in jingoism, or suggest that we should be complacent about our energy situation, the challenges of which I've blogged about for more than six years. However, while I understand the benefits of a little competition to get the juices flowing, I don't think it's helpful to portray the world's largest energy producer as an incipient also-ran. Moreover, defining such a competition entirely in terms of renewable energy seems myopic at best. Despite its importance as a strategy for reducing greenhouse gas emissions, renewable energy is eclipsed by the more relevant category of low-emission "clean energy", from which we derived nearly a third of our electricity last year. Nor are we or any of our global competitors anywhere close to being able to dispense with the fossil fuels that accounted for 84% of total US energy consumption in 2008.

The US is a continental economy and a leading producer and consumer of every significant type of energy. No "energy race" in which it would be sensible for us to engage can be reduced to a simple matter of who installed the most wind turbines or solar panels last year. While we shouldn't be shocked if another country leads in some aspects of energy technology, we also shouldn't lose sight of the larger context, because energy isn't an end in itself. Even if clean technology turned out to be the computer industry of this decade--in reality and not just hype--and we didn't come in first in the cleantech race--a result I'm not prepared to concede, yet--energy remains the servant of the rest of the economy. That's where the race that matters most will be won or lost.

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Renewable Energy and Domestic Content

The current scuffle between the US Congress and the wind industry began last fall with reports of a large wind farm in Texas involving both Chinese investors and Chinese wind turbines. It ratcheted up last week, with four key Senators proposing to close the "loophole" that enables renewable energy projects built with imported hardware to receive stimulus funds. The American Wind Energy Association (AWEA) promptly retorted that the problem wasn't the wind projects and their suppliers, but a lack of consistent renewable energy policies coming out of the Congress. The more I've thought about this situation, the more I am convinced that both parties to this tiff are missing the bigger picture.

Let's start with the response by AWEA, which used the occasion to reiterate their consistent support for a national renewable electricity standard they contend would provide a clear policy signal for anyone contemplating investing in the facilities and workforce needed to manufacture wind turbines, solar arrays and other renewable energy gear here in the US. That sounds good, but it's equally clear from the record rate of wind installations last year that demand wasn't the problem, nor was it lack of government incentives to stimulate that demand. The Production Tax Credit for wind power has already been extended through 2012 and seems unlikely to be allowed to expire again, and the Investment Tax Credit for solar was extended through 2016. For that matter, 29 states plus the District of Columbia already have Renewable Portfolio Standards of the type AWEA is advocating for the country as a whole, and many of the states without one lack good wind resources in any case. The main aspect that has been in contention is whether the option to convert these tax credits to up-front cash grants--the benefit at the heart of the controversy over foreign-sourced wind turbines--should be extended beyond the end of this year. On the whole, then, the uncertainties faced by wind manufacturers don't look any worse than those confronting other manufacturers, and they might not even be as bad.

Next consider the complaint of the four Senators that such renewable energy grants ought to be reserved for projects that create green jobs here in the US, rather than overseas. This concern was prompted by a study suggesting that the lion's share of such grants to date has gone to non-US firms. While that negates most of the Keynesian stimulus benefits of the policy, it's also a nearly-inevitable result of the way that global manufacturing is now structured. Expecting all wind turbines funded by stimulus grants to be stamped "Made in USA" is no more realistic than expecting every car, computer, and paperclip paid for by stimulus money to have been made by American workers in an American factory. For good or ill, we don't live in that world anymore, and that's one reason that the entire federal stimulus has been less effective than hoped in promoting domestic employment: a large fraction of what we consume is either made elsewhere or includes many non-US components. Although wind turbine manufacturing started as a small, localized undertaking in the US and a few European countries, it has grown with extraordinary speed during precisely the same period that the supply chains of numerous industries became thoroughly globalized.

While these trends of manufacturing globalization and blanket support for renewable energy set the stage for it, the current collision over domestic content in the wind industry is the direct consequence of the pervasive green jobs theme that both politicians and advocacy groups like AWEA adopted for similar reasons of expediency last year: how else do you justify spending billions in tax dollars on this sort of thing during a recession, if it doesn't stimulate the US economy and create lots of jobs?

The solution to this conundrum is tricky. Since it's unlikely that either side can now admit that green jobs have been oversold as a justification for renewable energy policies, both sides ought to focus their efforts on manufacturing, and by that I don't mean just throwing up a few final-assembly plants where imported turbine parts can be bolted together, but rather addressing the factors that have affected US competitiveness across a wide range of industries. That includes high corporate tax rates, weak tax incentives for manufacturing investment, and the stifling overlap in federal, state and local regulations. More urgently, it should be clear that the solution does not involve erecting trade barriers in the form of domestic-content rules that would provoke retaliatory measures that would harm successful US export sectors. Nor does it include obscuring the magnitude of renewable energy subsidies by moving them out of the federal budget--where they are at least visible--and into the cost base of utilities by converting them into renewable energy mandates. While it might be appropriate to shift the burden from taxpayers to ratepayers, the industry needs smart incentives, not a perpetual subsidy along the lines of corn ethanol (three decades and counting.)

I used to think that all of these arcane and inefficient incentives could be swept aside by putting a price on greenhouse gas emissions, via either cap & trade or a carbon tax. I'm now skeptical about that, because of the way that Congress has insisted on combining cap & trade with a renewable electricity standard plus direct, technology-specific subsidies in the Waxman-Markey bill and its siblings. The spectacle of the US Treasury writing checks for hundreds of millions of dollars to Spanish and Chinese wind turbine companies is the inevitable result of this kind of convoluted thinking.

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A Self-Fulfilling Bet on Biofuels?

An article in today's Financial Times (registration required) raises a worrying possibility concerning the plans of the US and other oil-consuming countries to rely on biofuels for an increasing fraction of future fuel needs. What if oil-producing countries took those plans seriously and reduced their investment in new oil capacity, on the assumption that it wouldn't be needed? In some respects, that's exactly what we have in mind. However, if biofuels then failed to materialize in sufficient quantities to fill the gap between oil supply and total fuel demand, or proved to be economically or environmentally unsustainable, then we might inadvertently create precisely the sort of crisis these efforts were intended to avert. It would be easy to dismiss this argument as OPEC-inspired propaganda, if global oil production didn't require enormous ongoing investments to counteract the natural decline rates of producing fields, and if producing-country governments weren't already under internal pressure to spend their oil profits on programs other than reinvesting in future production.

The good news here is that biofuels have reached a scale at which they actually matter in the global oil supply and demand balance. That wasn't the case during the oil crises of the 1970s, and they were still only a marginal factor when oil prices last peaked in 2008. The latest publicly-available issue of the International Energy Agency's Oil Market Report indicates that biofuels now contribute the equivalent of 400,000 barrels per day (bpd) of oil, before including US and Brazilian ethanol volumes that together equate to another 650,000, bringing the global total to just over a million bpd. That might not sound like a large share of a total market of 85 million bpd, but it's enough to influence the global price of oil, which is set at the margin. Doubling or tripling biofuel output would certainly cost oil producers money, if they ignored this factor in their capacity planning.

So far, this is only a problem for oil producers. It becomes a problem for the rest of us when the biofuel plans and targets of consuming countries are based on unproven technology that may not be able to deliver in time, or possibly at all. Unfortunately, that's the position in which we find ourselves. Consider the Renewable Fuel Standard (RFS) enacted by the Congress in 2007 and refined in new regulations issued by the Environmental Protection Agency. Out of the 36 billion gallon per year target for 2022, only around 16 billion gallons is accounted for by corn-based ethanol and first-generation biodiesel--both of which have been amply proven, however much they depend on generous subsidies to remain competitive. 20 billion gallons per year must come from cellulosic ethanol and other advanced biofuels, none of which are in truly commercial production today, in spite of the hype that has been generated by a handful of "demonstration facilities."

One indication of just how unrealistic these targets might be is that EPA was forced to reduce the cellulosic biofuel target it will enforce for 2010 from 100 million gallons to 6.5 million gal.--the equivalent of just over 400 barrels per day of oil--due to lack of supply. And while the agency attributes that shortfall to delays in starting up new facilities using a variety of new technologies, a careful reading of their analysis suggests the problem might be more serious than that. Two firms account for nearly a third of the 694 million gallons of cellulosic biofuel capacity they expect will be in operation by 2014, Cello Energy and Range Fuels. Unfortunately, last year Cello was ordered by a federal court to pay $10 million for defrauding investors concerning its technology claims. Meanwhile blogger Robert Rapier has documented the problems that Range Fuels has experienced in scaling up its process for producing ethanol from gasified biomass. Until both of these firms have demonstrated they can actually do what they claim, at full scale, it's not prudent to bet the ranch on their production forecasts.

Problems such as this are probably just the tip of the iceberg when it comes to scaling up a myriad of new processes for producing motor fuels from non-food biomass, not because it's impossible or because the firms involved don't have sufficient smarts--though one or both of those factors will turn out to apply in at least a few cases--but because it is intrinsically hard. Scientists have been working on cellulosic biofuels and biomass-to-liquids processes for decades, yet the sum total of all that work, up until this point, has only yielded enough fuel production to cover the annual consumption of about 13,000 average American cars. That doesn't mean that companies and investors are foolish to pursue these technologies, or that ExxonMobil is wrong about the potential they apparently see in algae-based fuels, another hot biofuels sector. What it does mean, however, is that when dealing with technologies that can't be made to appear on command and are subject to a number of serious, unresolved technical and logistical challenges, neither consumers nor our governments should base their plans for the future on the assumption they will mostly succeed on schedule.

How realistic is it that the oil-producing countries that control access to the vast majority of the world's oil reserves would be so convinced by our rhetoric concerning biofuels replacing oil, that they will cut back their investments in new capacity? Part of the answer lies in the narrative of Peak Oil that generated headlines when oil prices were spiking a couple of years ago, involving the high decline rates of mature oil fields and the relatively low investment rates of many producing countries. When the government of Venezuela must borrow money from China despite $80 oil, that's one signpost that they might not have enough to reinvest in exploration and production. We can argue about the likely date of a peak in global oil output, but anything that provides governments an excuse to spend less sustaining their oil industries brings that date closer--and that's equally true for a US administration that appears so confident of the success of its biofuels and fuel economy programs that it can allow the timing of the next offshore oil leasing cycle to slip further and further.

Oil is still the lifeblood of our industrial civilization, but it's also a business requiring enormous investments premised on the likelihood of future demand. That doesn't mean we must remain helpless hostages to foreign oil suppliers; fuel efficiency and biofuels are both sensible--even necessary--strategies for us to pursue. But we have an even larger stake in ensuring that the biofuel goals and plans we communicate, not just among ourselves but simultaneously to our oil suppliers, are based on reality. If both we and they are betting on supplies of advanced biofuels that could well fall significantly short of our expectations, then it is we who will suffer the consequences at the gas pump.

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Wind vs. Natural Gas

Today's Wall St. Journal includes a very interesting article on the real-world competition between wind power and electricity generated from fossil fuels. At least in Texas, steadily increasing wind generation has apparently come mainly at the expense of natural gas, rather than displacing coal-fired power, as might have been anticipated by many wind advocates. That has implications for the effectiveness of renewable energy policy as a means of reducing greenhouse gas emissions, as well as for the utilities and independent power generators that are complaining that wind has been given overly-preferential treatment.

Texas makes an interesting laboratory for demonstrating the practical consequences of our shift towards renewable energy. ERCOT, the Texas grid, has little connectivity with neighboring grids; power generated within Texas must, for the most part, be used in Texas, while demand in Texas must be met mainly by generators within the state. That makes the relationship between wind and fossil fuel generation more transparent than it would be in another region with larger imports and exports. The resulting statistics on gas generation displaced by wind, as presented in the article, are unlikely to surprise those familiar with the technologies involved.

As I've pointed out periodically, wind power is unlikely to displace much coal, since most coal plants are mostly run in baseload mode--essentially 24x7--because that suits both their operating requirements and the grid's need for large quantities of predictable, low-cost power to handle routine loads. By contrast, wind turbines rely on the availability of wind blowing at speeds within a specified range. On average they put out about 30% of the full power for which they're rated, in patterns that vary from day to day and season to season. Gas offers much more flexibility than either coal or wind and is thus the supply most likely to be adjusted up or down to accommodate the output from wind when it's blowing or back-stop it when it's calm. From what I can tell from the article, the complaint from gas-based generating companies isn't that this is occurring, but that when wind generators come up short vs. their day-ahead commitments to the grid, the penalty falls on everyone else, not on the responsible wind farms. This constitutes a hidden subsidy, on top of the ongoing benefit of the federal Production Tax Credit (currently available as an alternative Investment Tax Credit and payable as an up-front cash grant) and the Renewable Energy Credits generated under the state's Renewable Portfolio Standard.

This competition has important implications for energy policy, and not just because backing out power from gas saves nearly 40% fewer greenhouse gas emissions than backing out coal power. It also exposes real, practical differences that go well beyond the typical incumbent vs. new entrant issues characterized in the article, by the head of the American Wind Energy Association. Because these distinctions are grounded in physics and engineering, it isn't just a question of whether the existing rules favor one otherwise equivalent technology over another, or whether wind farms are getting a free ride at the expense of other suppliers, but how to design a system that makes the best use of all these resources, including the atmospheric emissions sink. This goes to the heart of how we build a generating mix with increasing proportions of supply from technologies that are intrinsically different and less dependable than those we've relied on historically.

On one level, this is part of what the emerging smart grid is supposed to address, but it also presents a very real business problem that can't be solved by pretending that all electrons are equally valuable to the grid. The goal of greening our power supply must coexist with the goal of improving the capability of the entire grid to provide reliable, high-quality power for an economy that is increasingly dependent on electricity. If we want all power market participants to invest toward achieving that end, then we must find a way for wind and other renewables to shoulder their fair share of the burdens, rather than shifting them onto their direct competitors. That might require wind farms to contract for their own back-up coverage with gas generators, if they expect their commitments to be treated as equivalent to those from other suppliers. Or perhaps it makes the case for phasing out wind's production-based tax credits in favor of federal insurance to cover the penalties that result from its intermittent output under dispatching rules that don't favor any generating technology.

While some might dismiss the Texas situation as growing pains or whinging by those that have lost out to wind, I see further confirmation that the successful integration of new technologies into our energy mix requires more than just investment incentives and wishful thinking. If we want to capture the natural synergies between wind and gas--both of which have desirable attributes--then we must find ways to make them compatible as actual businesses, not just on paper as theoretical technologies.

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Oil Price Hangover

The price of oil is an odd thing. It's watched by millions of people every day, especially when it reaches uncomfortable levels, yet no two observers agree on all the details of how it's determined. Having traded the stuff professionally, I've always given a lot more credence to the fundamentals of supply and demand than to the influence of speculators as the main driver of day-to-day price movements, though it's clear that both supply and demand are pretty complex constructs in their own right these days. For some time, however, I've also been intrigued by the extent to which current oil prices seem to be affected by their own history, something more in keeping with behavioral economics than the kind I learned in grad school. When I consider all the factors converging to yield this morning's price for the prompt (April 2010 delivery) West Texas Intermediate crude oil futures contract, it's hard to rationalize a value just over $80 per barrel any other way, without taking into account that less than two years ago it was nearly $150 per barrel-- though just a year ago it stood at $40, after a dip into the mid-$30s.

Over the weekend I happened to look back at some scenario work I did almost six years ago, when oil prices were rising steadily but before they had passed the $50 per barrel mark for the first time. Though it seems hard to credit now, at the time even that milestone seemed nearly unimaginable for the group of energy industry managers participating in the workshop I was leading. WTI had just broken through $40/bbl, which represented the highest nominal oil price any of us had seen in our careers, a record set in the lead-up to the first Gulf War. Although the prices in the early 1980s, after the Iranian Revolution, were higher on an inflation-adjusted basis, we had just lived through a couple of decades in which oil had notably failed to keep up with general inflation. Of course from our current vantage point $40 or $50 now seems cheap, and that's precisely the point. With an all-time high of $145 still relatively fresh in memory for "anchoring" purposes, $80 might not seem low, but it hardly provokes the kind of anxious political pronouncements that flavored the 2008 US presidential campaign.

Things couldn't be more different than the first time we passed $80/bbl in September 2007, when there was much talk of the risk premium on oil prices due to tensions with Iran, as well as the impact of a weakening US dollar. Most importantly, the global economy was still booming and OPEC was having trouble keeping up with growing demand, particularly from the developing economies of China and the Middle East oil producers themselves, along with the US at the tail end of the bubble. By contrast, despite expectations for a recovery in 2010, today's oil market is dominated by weak demand, with average US demand for oil and its products in 2009 down by 10%, or 2 million barrels per day (MBD) from '07. The global appetite for oil fell by 1.5% in 2009, with only Asia and the Middle East registering any growth. Inventories are ample, refineries are running at extremely low rates of utilization--partly due to some ill-timed capacity increases--and OPEC has as much spare oil production capacity as it did in 2003, when WTI was in the $30s.

So why isn't oil back in the $30s or $40s, rather than the $70s and $80s, particularly with the dollar having strengthened by almost 6% since the beginning of the year? Certainly a big part of the credit or blame, depending on your perspective, belongs to OPEC, which has managed to take 2-3 MBD of production off the market and keep it there, with minimal cheating and without triggering a price war driven by members whose national budgets needed significantly higher oil prices or sales to balance. It's also clear that since the beginning of the last decade the marginal cost of incremental non-OPEC production has gone up significantly, whether from Canadian oil sands or deepwater Gulf of Mexico platforms. Part of that is due to the fact that these are intrinsically costlier barrels to produce, but it also owes a lot to the costs of raw materials and construction involved. Those soared during the last decade, weakening subsequently but not returning to their former levels. That means that the much lower oil prices we saw briefly at the end of 2008 and beginning of 2009 aren't sustainable for any length of time, though precisely where a realistic floor now lies is anyone's guess.

Arriving at a price of $80/bbl despite slack demand, ample global supply and a refining sector that's losing money doesn't require nefarious speculation, but it probably depends on two crucial factors: Most oil deals today are negotiated as a stated premium or discount relative to a handful of grades like WTI and Brent that involve as many financial players as refiners who must process the stuff and try to make a profit on it. And for those few, correspondingly more influential markets in which traders must negotiate an actual price and not just a differential, traders' price expectations are anchored by the history of the last couple of years. Once you've seen oil above $100 without the world ending--though it came close--you simply can't look at the market the same way you did before. If the range of possible prices is now seen as $40-$150, rather than $15-$35, today's circumstances understandably yield a mid-range interpretation, backed by an expectation that OPEC would intervene even more strongly if prices began falling towards that uncertain floor--a threat the credibility of which is greatly enhanced by OPEC's remarkable cohesion and discipline over the last year or so, perhaps providing more psychological anchoring in the form of availability bias.

So in a strange sort of way, we may still be experiencing the consequences of the extraordinary oil price spike of 2007-8, which was itself either an outgrowth of the global financial bubble, or a major, independent contributor to the ensuing collapse, in classic oil-shock fashion. While the extreme prices of that period have receded, they haven't vanished from the market's memory, and so they may continue to influence prices for some time to come, until the next spike or oil-price collapse resets them again.

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