The New and Improved CTL Scheme

“In theory, there is no difference between theory and practice. But, in practice, there is.” – Jan L. A. van de Snepscheut

A very short paper (two pages) appeared in the latest Science detailing an improvement on coal-to-liquids (CTL) technology. A couple of people have e-mailed me to ask for my take on it. You can get the executive summary from the quote at the top, or from my version, which is:

“In the world of energy, people sometimes have trouble distinguishing make-believe from reality.” – Me

Wired Magazine weighed in on the (subscription-only) Science report – Producing Transportation Fuels with Less Work – a few days ago:

Bad News: Scientists Make Cheap Gas From Coal

If oil prices rise again, adoption of the new coal-to-liquid technology, reported this week in Science, could undercut adoption of electric vehicles or next-generation biofuels. And that’s bad news for the fight against climate change.

The new process could cut the energy cost of producing the fuel by 20 percent just by rejiggering the intermediate chemical steps, said co-author Ben Glasser of the University of the Witwatersrand in Johannesburg, South Africa. But coal-derived fuel could produce as much as twice as much CO2 as traditional petroleum fuels and at best will emit at least as much of the greenhouse gas.

“The bottom line is that there’s one fatal flaw in their proposed process from a climate protection standpoint,” Pushker Karecha of NASA’s Goddard Institute for Space Studies wrote in an e-mail to Wired.com. “It would allow liquid fuel CO2 emissions to continue increasing indefinitely.”

The Wired story has spread like wildfire. I have seen numerous references to it. It has spawned lots of debate over whether it is desirable to increase our usage of coal. But one important detail seems to have been overlooked: It’s not real.

So what’s the story? Here is a clue, from early in the paper:

We outline reaction chemistry and processing designs that could dramatically reduce these energy inputs and minimize the amount of CO2 emissions that would be emitted or mitigated by other costly strategies, such as carbon capture and sequestration.

This is a ‘process’ only in that it has been drawn up on paper. This isn’t even at the stage of lab scale. This is Step 1: You have an idea. Next comes the step where you try to economically evaluate the implications, and then if they are favorable you start doing some laboratory experiments. This is the stage where probably upwards of 90% of all ideas that were thought to be good fail because the theory overlooked something that turns out to be a problem in the lab.

However, if the lab studies look good, you go on to build a pilot plant to demonstrate the concept at a larger scale. Again, the majority of the ideas that make it past the lab stage get weeded out at this stage. You have situations like CWT building a pilot plant only to find out that they have an odor problem that didn’t seem all that bad in the lab. Or you find out that while the front end of the process works well in the lab, and while the back end works well, when the front is connected to the back there is a problem. Maybe the front end produces a trace impurity that is a real problem for the catalyst in the back end. In the lab, this wasn’t a problem because you were simulating the back end with gases from a cylinder. However, those gases were of a higher purity than what you are producing now in the pilot plant. The list of land mines is endless.

None of this suggests that this is an idea without merit. But an idea is not a process, and so Wired got a little carried away with their description. In fact, the Science paper heavily references Sustainable fuel for the transportation sector (PDF) by Rakesh Agrawal et al. at Purdue. Theirs is another proposed process. It is called the H₂CAR ‘process,’ and is another idea in need of some laboratory testing. For a layman’s explanation of H₂CAR process, see:

H2CAR could fuel entire U.S. transportation sector

For a more detailed technical (and skeptical) view see:

H2CAR: Another blind alley

In that essay Engineer-Poet (of The Ergoshpere) concludes that this idea is doomed to die once the economics are considered fully.

But the bottom-line here is that it is important to distinguish between what is real and what is make-believe. A process that has survived lab tests or that is successfully being piloted is real. A process that only exists on paper is make-believe, and should be recognized as such. That’s not to say that the make-believe process won’t some day turn into a real process, but the lab has an uncanny ability to kill a lot of seemingly great ideas.

Yes He Could

Feasible? Yes. Realistic? No.

Do I believe the U.S. can be energy independent? Yes, I believe that with certain draconian measures, the U.S. could achieve energy independence within 10 years. But emphasis must be placed on ‘draconian.’ So yes, I think Barack Obama could make good on his campaign promises and make the United States energy independent. However, it would almost certainly make him a one-term president because the population would rebel at the cost of energy independence.

I covered the expected contribution of renewables to the U.S. electricity picture in The Nuclear Comeback. Conclusion? They better start building more nuclear plants if the administration wants to move away from coal. So let’s have a look at the oil picture and get our heads around just what energy independence might look like.

We Use a Lot of Oil

Here are some numbers, courtesy of the Energy Information Administration’s database. In 2008, the United States consumed 19.4 million barrels of oil per day (bpd) and produced 6.7 million bpd (including LNG). We imported 12.9 million bpd. (You may notice that there is a 0.2 million bpd discrepancy, which is partially caused by changes in inventory levels). So, in order to bring the United States to a state of energy independence, we have to somehow eliminate those imports through some combination of decreased demand and/or increased supply.

One way the U.S. could be energy independent is if we reduced our consumption by 65% to 6.7 million bpd. This would take the 23.6 barrels consumed in 2008 by the average person in the U.S. down to 8.3 barrels. That would put U.S. per capita consumption of oil between that of Croatia and Mexico. For reference, here is a sampling of per capita consumption of oil from various countries around the world (extracted from Energy Statistics – Oil – Consumption (per capita) (most recent) by country).

Country	Per Capita Oil Usage (bbl/yr)
Saudi Arabia	30.6
Canada	25.9
USA*	23.6
Australia	17.3
Japan	14.3
Germany	10.9
UK	10.6
Croatia	8.4
Mexico	7.1
Brazil	4.6
Egypt	3.2
Afghanistan	0.06
Chad	0.05

Table 1. Oil Per Capita Energy Usage for Selected Countries

* Oil usage for the US is from 2008; usage for all other countries is from 2007.

So the US could still use almost twice the per capita consumption of Brazil and achieve energy independence (because we produce a lot more oil per capita than Brazil). But how likely are we going to be to reduce our consumption levels down to less than that of Germany or the UK? It’s hard to imagine unless oil becomes very, very expensive. But that’s an option. President Obama could make oil very expensive and potentially pull usage down toward U.S. production levels. Of course in the process, the recession would probably deepen and Obama would lose the election in 2012. More on that later.

Can Renewables Fill the Gap?

But that’s not the plan. The plan primarily involves filling the supply gap, with renewables as the most important part (see quotes below) of that plan. So what might renewables contribute? There are lots of small contributions from areas like corn ethanol and soy-based biodiesel. But let’s put those in perspective. In 2008, the US produced a record amount of ethanol: 9 billion gallons. How much does that amount to, given our need to close a gap of 12.9 million bpd of imported oil in 2008? Converted into barrels per day, 9 billion gallons per year amounts to 0.59 million barrels per day on a gross basis, but because of the lower BTUs it would only displace 0.32 million bpd. (The BTUs per gallon for a barrel of oil are higher than for gasoline; relative to oil, ethanol has 54% of the BTUs per gallon). For the purposes of this exercise, we will pretend for a moment that there aren’t big quantities of fossil fuels that enabled that 9 billion gallons.

Thus, last year’s record ethanol production is a drop in the bucket relative to the oil we use. How much ethanol – as a reference point – would we need to close that gap? Given that last year’s ethanol production in theory already should have displaced some level of oil, there is a gap of 12.9 million bpd to close with incremental ethanol. How about an additional 364 billion gallons, or more than 40 times last year’s record number? For reference, global ethanol production in 2008 is estimated to be 17.3 billion gallons.

Campaign Promises Revisited

I don’t know about you, but I don’t see any combination of renewables being able to close a gap like that. Remember what Obama said during the campaign?

We have to have energy independence, so I’ve put forward a plan to make sure that, in 10 years’ time, we have freed ourselves from dependence on Middle Eastern oil by increasing production at home, but most importantly by starting to invest in alternative energy, solar, wind, biodiesel, making sure that we’re developing the fuel-efficient cars of the future right here in the United States, in Ohio and Michigan, instead of Japan and South Korea.

Note what is “most important” in the drive for energy independence. To me, this is an example of someone who either doesn’t understand the scale of the issue, or someone who is just trying to score debate points.

Later on he elaborated:

The second point I want to make is — is the issue of energy. Russia is in part resurgent and Putin is feeling powerful because of petro-dollars, as Senator McCain mentioned. That means that we, as one of the biggest consumers of oil — 25 percent of the world’s oil — have to have an energy strategy not just to deal with Russia, but to deal with many of the rogue states we’ve talked about, Iran, Venezuela.

And that means, yes, increasing domestic production and off-shore drilling, but we only have 3 percent of the world’s oil supplies and we use 25 percent of the world’s oil. So we can’t simply drill our way out of the problem.

What we’re going to have to do is to approach it through alternative energy, like solar, and wind, and biodiesel, and, yes, nuclear energy, clean-coal technology. And, you know, I’ve got a plan for us to make a significant investment over the next 10 years to do that.

And I have to say, Senator McCain and I, I think agree on the importance of energy, but Senator McCain mentioned earlier the importance of looking at a record. Over 26 years, Senator McCain voted 23 times against alternative energy, like solar, and wind, and biodiesel.

And so we — we — we’ve got to walk the walk and not just talk the talk when it comes to energy independence, because this is probably going to be just as vital for our economy and the pain that people are feeling at the pump — and, you know, winter’s coming and home heating oil — as it is our national security and the issue of climate change that’s so important.

How About Drilling?

Those are certainly reasonable comments, but they won’t make us energy independent. Also, because the talk of drilling from Obama started just as McCain was gaining some traction with the ‘drill here, drill now’ campaign, many people felt like it was a campaign promise that wasn’t destined to be carried out in an Obama administration. However, it looks like Obama has looked at the issue closely enough to recognize that new production is going to have to be part of any energy independence plan that has any chance of success any time soon:

Obama to Remake Drilling Policies

Wesley Warren, director of programs at the Natural Resources Defense Council, said, “They have made a commitment to really be science-based, to look at all the facts before they make a decision. It is a new way of doing business.” The early signals from Obama and his cabinet agencies speak to that new way. Shortly after taking office, the president reversed orders issued in the closing days of the Bush administration that would have dramatically expanded offshore drilling.

Still, the Interior Department went ahead this week with a long-planned auction of drilling tracts in the Gulf of Mexico.

And Interior Secretary Ken Salazar has indicated in recent days that he’s looking for ways to expand offshore drilling in an environmentally conscious way. He has even said he’s open to allowing limited drilling at Alaska’s Arctic National Wildlife Refuge if it can be done from outside the refuge. “Oil and natural gas are, and will remain for many years to come, a cornerstone of our nation’s energy base,” Salazar told the American Petroleum Institute Thursday. “This is not, as some have suggested, a war on the oil and gas industry.”

There are still plenty of skeptics:

[Charles] Drevna of the National Petrochemical and Refiners Association said he’s concerned about Obama’s “anti-oil-refining-industry rhetoric,” the suggestion that big energy companies should face higher taxes as the nation shifts toward renewable sources.

“It is this talk about energy independence; it’s not achievable, and it probably is not desirable,” Drevna said. “Energy independence means energy isolation, and we simply cannot afford it if we expect the economy to grow.”

One could expect that we could open up offshore areas of the U.S. and potentially get some incremental production, but the administration certainly doesn’t plan to make it easy. They have more or less declared open season on the oil industry, and are pursuing policies that are certain to discourage U.S. oil production. Geoff Styles recently discussed the folly of punishing our own oil industry in The Wrong Enemy. Excerpts from his article:

I would paraphrase the Obama energy strategy as seeking to reduce US oil imports and greenhouse gas emissions by strongly promoting renewable energy and energy efficiency. Unfortunately, the administration’s actions risk putting the domestic oil and gas industry on the wrong side of the divide that creates.

Rather, we need to look to our self-interest, here. When an oil company drills in the US, its production backs out imports directly, barrel for barrel. It pays US salaries–attractive ones–and it pays hefty taxes: income taxes at a 40% effective rate, along with billions of dollars in royalties, rents and bonus bids collected by the government. When a US oil company drills elsewhere, much of the benefit is captured by foreign governments, and when the oil we import comes from a non-US supplier, our trade deficit swells and the federal government only gets to tax the profits on refining & marketing, which are often pretty thin.

Styles argues that the policies that are being pursued will almost certainly result in an increase in U.S. oil imports. If U.S. production is discouraged – and renewables aren’t up to the task of filling the gap – then guess what? Our imports will increase, and we will increase our energy dependence.

A How To Guide to Energy Independence

So how would I go about making the U.S. energy independent? As I said, it would require draconian measures. First, I would try to increase supply by incentivizing all forms of energy production. As I argued in an essay last year, I would use the proceeds of expanded offshore drilling to fund higher efficiency vehicles, electric transport, mass transit, and biofuels that aren’t highly dependent upon fossil fuels for their production. This should start to pull supply and demand closer together. But even my most optimistic scenario would still require substantial oil imports.

To close the rest of that gap requires the draconian piece. There are two choices. One is to ration fuel. Imagine that you had to get by on half the fossil fuel you normally use. Could you? I think most people – if they really dug down – could do it. It wouldn’t be easy, and we would certainly lose a lot of convenience. Someone complained to me last year that when gasoline got up to $4 a gallon, it was a real inconvenience for the family because they had to start consolidating trips. Boo-hoo. Nobody said it was a piece of cake; if it was we would already be energy independent.

The other option is to ration by price. The problem with this one is that there really isn’t a good feel for what kind of prices it might take to bring consumption in line with production. It could take $20/gal gasoline. Could we afford that? I would argue that we could, if the incremental gasoline tax was offset by income tax cuts. I have covered what I think would be a politically viable scheme for increasing carbon taxes in The Case for Higher Gas Taxes. But again, the problem with this option is that we don’t have a good model for how high the price would need to go before destroying enough demand.

But in my opinion, this is what it would take to become energy independent within the next decade. There is a reason that countries in Europe – with their mass transit and fuel efficient vehicles – still can’t achieve energy independence. It’s hard. It will always be difficult to achieve in a Democracy, where you have to make the voters happy lest you be voted out of office. Voters who have to make big sacrifices don’t look favorably on political leaders who ask for it.

Therein lies the problem for Obama. Yes, he could. But not with the policies he is pursuing. So, at the end of the day, “No, He Won’t.”

Aventine, Verenium on the Ropes

Reality is starting to catch up with prospective cellulosic ethanol producers. I felt like this was bound to happen, but the poor economy is making it happen faster than I expected. I expected some plants to be built, and then they would bleed red ink for a while before declaring bankruptcy. But many are running into trouble before breaking ground on a plant:

Time Running Out For Aventine

Late Monday, Aventine Renewable Energy Holdings (nyse: AVR – news – people ) announced it didn’t expect to have enough capital to cover an upcoming $15.0 million interest payment due April 1 on an outstanding senior unsecured 10.0% fixed-rate note or to pay $24.4 million due to its engineering and construction contractor, Kiewit Energy. It also said it may need to seek Chapter 11 bankruptcy protection if it cannot raise the cash.

Aventine was also delisted this week from the New York Stock Exchange:

NYSE delisting ethanol producer Aventine

The NYSE said the Pekin, Ill.-based company’s market cap fell below its required $15 million level for 30 consecutive days. The exchange recently relaxed the rule from $25 million because of market volatility and decline.

While “Aventine has had a cellulosic project underway since 1990“, I don’t believe they had announced a facility. Verenium, on the other hand, had been in the news for an announced $300-million cellulosic ethanol plant in Florida. The only problem is, they need $300 million:

Auditor questions Verenium’s ability to continue

An outside auditor for Verenium Corp. said in a filing Monday that the advanced biofuels company may have to “curtail or cease operations” if it cannot raise additional capital. Verenium, in an Ernst & Young audit opinion included in a year-end report filed with the Securities and Exchange Commission on Monday, said its operating plan and existing working capital deficit raises doubt about its ability to continue.

“We continue to experience losses from operations, and we may not be able to fund our operations and continue as a going concern,” Verenium said in the filing. The company said it will need additional capital to fund operations, including about $300 million to complete its commercial cellulosic ethanol plant with BP.

In a related story, I am announcing my plans to build the world’s largest algal biodiesel plant in Texas. But I will need someone to loan me $800 million so I can build the 20 barrel per day facility.

As I noted in an essay last month, capital costs for the proposed Verenium facility are quite high relative to comparable corn ethanol plants which are themselves struggling to survive. I speculated that Verenium would be not be able to make cost-competitive ethanol, and would only survive via mandate. Looks like even that may have been too optimistic.

In the long run, though, I stand by my assessment that conventional cellulosic ethanol will never be viable. I just wonder how many tax dollars we will throw at the problem before it is widely recognized.

The Next Five Years

Peak Lite and the Current Oil Picture

A few years ago, after spending a lot of time thinking about peak oil, and then watching the price of oil break out of its historical trading range and head higher, the idea of Peak Lite came to me. Over time the price of oil had bounced between $10 and $30 a barrel, but about 5 years ago it broke from that pattern and started the steady climb that culminated in $147/bbl last summer. I had been having various debates about whether we were or weren’t at the global peak in oil production (I was taking the ‘not yet but soon’ position), but it started to become clear to me that we didn’t require a global peak before we started to feel the impact of peak oil.

I proposed the following to explain what I thought was happening. (Don’t get too fixated on the dates or prices as they are just there to illustrate the concept). Figure 1 shows the sort of price behavior if spare oil production capacity is constant. Of course spare production fluctuates up and down, as does price, but my thesis is that constant excess capacity should keep the price relatively stable – as long as the excess is large enough that several different producers have the ability to step up and fill shortfalls. This concept is illustrated by Figure 1, with a constant four million barrels per day (bpd) of excess capacity and an oil price of $25/bbl.

Figure 1. Simulated Oil Price Behavior at Constant Spare Capacity

Figure 2. Simulated Oil Price Behavior at Eroding Spare Capacity

Figure 2 illustrates the case in which demand growth is outstripping supply growth, leading to diminishing spare capacity. This is the mode that we have been in for the past few years. Spare capacity was eroded by several million barrels during the first half of this decade, and as a result the price of oil climbed higher, and became increasingly volatile. This was caused by a combination of stronger demand worldwide, and an oil industry that had not anticipated such strong demand growth. As a result, the global oil industry didn’t invest aggressively enough to meet demand, and while capacity did grow, it didn’t grow quickly enough to keep prices stable.

Figure 3. The Next Five Years?

Figure 3 illustrates a future in which world demand has collided with world supply, and then demand growth continues to stay ahead of supply growth. In the world of peak oil, this happens because supply is falling. In the peak lite world, it can occur even if supply is increasing. In the figure, I show an example of supply and demand colliding in 2010, then demand exceeding supply in future years. Of course demand as defined in Economics 101 won’t actually exceed supply, demand will just be destroyed by rising prices (as shown on the right axis) to keep it in equilibrium with supply. Figures 2 and 3 illustrate what Peak Lite is all about; that you don’t have to have falling supplies to start experiencing the effects of peak oil.

I created the original figures in mid-2007, and as we know by mid-2008 oil prices had risen much higher than the $95/bbl I illustrated on the figure. But circumstances have changed. As a result of climbing oil prices, new projects have begun to come online. Strong price signals from the previous five years had resulted in major investments into new oil production (but it takes a few years to bring new projects online); about 5 million bpd of new capacity was expected to come online in 2008 alone.

At the same time, oil prices climbed much too quickly for the economy to even begin to adjust, and this contributed to the overall economic collapse. The combination of high prices and the economic troubles have taken a bite out of demand (at least temporarily). So we essentially find ourselves back in the position of having perhaps three or four million barrels of excess capacity around the world, and oil prices back in the $40’s. Thus I think Figure 4 explains where we are now – and where I think we are headed.

Figure 4. When Do Prices Bounce Back?

In Figure 4, the year 2007 shows a world in which oil is at $80 and the demand has nearly caught up with supply. 2008 shows an example of no spare capacity, and the oil price sharply higher. Then 2009 shows the situation with reduced demand, some incremental capacity increase over 2008 (new projects scheduled to come online in 2009 will generally be too far along to cancel), and the corresponding price collapse arising from the largest spare capacity situation in several years.

So, where do we go from here? I think it depends on how quickly demand bounces back.

The Next Five Years

What might the next five years look like? Do we revert back to Figure 1, in which we see steady prices for years (except this time in the $40 region)? Or do we return to the eroding capacity case of Figures 2 and 3? I have reason to believe the latter is the case.

One reason for this is that the oil industry needs higher prices to warrant new projects. Sig Cornelius, the Chief Financial Officer of ConocoPhillips, recently stated that oil needs to average $52/bbl in order for the company to break even. The cost of finding and developing oil has gone up, and recently Eni CEO Paolo Scaroni said that oil prices would need to be $60 to keep up the needed investments. As a result of low oil prices, drilling rigs are being underutilized and projects are being canceled:

E&P Capital Expenditure Cutbacks

The International Energy Agency estimates that about $100 billion of worldwide oil production capacity expansion projects have been cancelled or postponed over the past half year. According to Barclays Capital, oil companies have cut worldwide exploration and production spending by 18 percent so far this year. Deutsche Bank estimates that U.S. energy exploration-and-production spending will drop $22.5 billion this year, a 40-percent, year-on-year decline.

Saudi Arabia has cancelled the development of several fields such as the Manifa and Dammam oil field, which would have added about 1 million barrels per day (MMBpd) of capacity. Refinery projects have also been delayed or cancelled while Saudi Aramco reviews cost estimates in the light of the significant weakening of oil prices. Saudi Aramco will consider re-issuing a tender for Manifa’s development at a later date, assuming bids from contractors reflect a reduction in raw materials to match lower oil prices.

Such cancellations come at a price, which the article summarizes:

New oil-and-gas projects usually take several years of development before starting commercial production. According to Cambridge Energy Research Associates, the scaleback in exploration and production could reduce future global oil supplies by up to 7.6 MMBpd in five years, or 9 percent of current production. If demand suddenly comes back as it did in 2003-2004, there could be a resulting shortfall of production and much higher energy prices. The International Energy Agency (IEA) also warns that the credit crisis and project cancellations will lead to no spare crude oil capacity by 2013.

The longer oil prices stay low, the worse the shortfall will be due to the project cancellations and increasing demand. Incidentally, these factors also explain a big part of why the oil industry is historically cyclical; in the good times producers spend money, and then when supply gets ahead of demand and the price falls, they slow down on investing. This eventually leads to tightness again, so the good times return. The steepness of the World Oil Price curve in Figure 4 could be much steeper if demand recovers sooner rather than later.

The prospect of sharply higher taxes on the oil industry is a second factor that threatens to slow the development of new oil projects. A recent study by the American Petroleum Institute concluded that this number is “at least” $400 billion over the next 10 years. That seemed quite high to me, so I wrote to the API for a breakdown. Jane van Ryan, Senior Manager of Communications at the API, responded:

The figure is, according to our tax experts, “at least $400 billion” and could be significantly higher.

Using EIA numbers, our tax analysts have examined the impact on the industry of the administration’s cap-and-trade proposal using five scenarios. The results indicate that about 60 percent of the administration’s proposal, which would raise $645.7 billion in “climate revenues,” would be funded by the oil and natural gas industry. This means the industry would pay about $400-450 billion. We have opted to use the lower figure.

The industry’s share of business-wide tax provisions as well as new taxes on the industry are estimated at $80-90 billion over ten years. Again, we have opted to use the lower figure. These tax provisions include the reinstatement of the Superfund Tax, the repeal of the LIFO provision, internal enforcement/reform deferral/related tax reform policies, an excise tax levy on federal offshore leases in the Gulf of Mexico, the repeal of the enhanced oil recovery credit, the repeal of the marginal well tax credit, the repeal of the expensing of intangible drilling costs, the repeal of the deduction for tertiary injectants, the repeal of the passive loss exception for working interests, the repeal of Sec. 199 for oil and natural companies, the increase of the G&G amortization period for independent producers to 7 years, and the repeal of the percentage depletion for oil and natural gas.

While I won’t get into all of the pros and cons of new taxes, higher taxes will provide a disincentive for projects which are projected to have a marginal financial return. If this further contributes to underinvestment, it will worsen the overall tightness in the oil markets, which will put more upward pressure on prices. Thus, high oil prices will likely again be a campaign issue in the 2012 presidential elections.

Conclusions

While the oil industry is historically cyclical, I believe we are approaching the point at which the industry will no longer be able to build out enough new projects to stay ahead of demand. This could manifest itself as peak oil, in which case the rate of depletion permanently overtakes the rate at which new production comes online. Or it could first manifest as peak lite, in which case new production still stays somewhat ahead of depletion, but can’t keep up with new demand. In either of these situations, I think the historical cyclicality of the oil industry will disappear. In early 2008 I thought we had reached that point, but it appears that we had at least one more cycle ahead.

While it is too early to tell with a high level of confidence just where we are on the depletion curve, the summer of 2008 provided of taste of life in an oil-constrained world. The current level of underinvestment and the prospect of higher taxes are setting up another situation in which spare capacity erodes, leading to higher oil prices and greater volatility. Add to this the prospect of a global oil production peak, and I have trouble seeing a case where oil prices will remain stable in the coming years.

As an investor, I use blue chip oil stocks as a defensive measure against much higher prices. I am not one who subscribes to the idea that oil companies are going to be put out of business by running out of oil, or by ethanol, algal biodiesel, or any other combination of alternative fuel technologies. In fact, I strongly believe that if an alternative technology begins to look attractive enough, oil companies have deep enough pockets to shift their business in that direction. But I think that’s unlikely to happen any time soon.

As a consumer, it would probably pay to evaluate just how much higher prices might impact your budget – and then take action. Can you sustain oil prices that return to $150/bbl or more? Even if you can, do you want that uncertainty hanging over your budget? If not, then it would be prudent to take steps to minimize the personal impact of high oil prices. Steps to consider include utilizing more fuel efficient transportation, public transportation, ride-sharing, and if possible locating closer to your place of employment.

Plan ahead and don’t get caught off-guard like so many did last summer. It is only a matter of time before history repeats itself. Here’s hoping our political leaders make policy decisions that won’t worsen the impact.

The Next Five Years

Peak Lite and the Current Oil Picture

A few years ago, after spending a lot of time thinking about peak oil, and then watching the price of oil break out of its historical trading range and head higher, the idea of Peak Lite came to me. Over time the price of oil had bounced between $10 and $30 a barrel, but about 5 years ago it broke from that pattern and started the steady climb that culminated in $147/bbl last summer. I had been having various debates about whether we were or weren’t at the global peak in oil production (I was taking the ‘not yet but soon’ position), but it started to become clear to me that we didn’t require a global peak before we started to feel the impact of peak oil.

I proposed the following to explain what I thought was happening. (Don’t get too fixated on the dates or prices as they are just there to illustrate the concept). Figure 1 shows the sort of price behavior if spare oil production capacity is constant. Of course spare production fluctuates up and down, as does price, but my thesis is that constant excess capacity should keep the price relatively stable – as long as the excess is large enough that several different producers have the ability to step up and fill shortfalls. This concept is illustrated by Figure 1, with a constant four million barrels per day (bpd) of excess capacity and an oil price of $25/bbl.

Figure 1. Simulated Oil Price Behavior at Constant Spare Capacity

Figure 2. Simulated Oil Price Behavior at Eroding Spare Capacity

Figure 2 illustrates the case in which demand growth is outstripping supply growth, leading to diminishing spare capacity. This is the mode that we have been in for the past few years. Spare capacity was eroded by several million barrels during the first half of this decade, and as a result the price of oil climbed higher, and became increasingly volatile. This was caused by a combination of stronger demand worldwide, and an oil industry that had not anticipated such strong demand growth. As a result, the global oil industry didn’t invest aggressively enough to meet demand, and while capacity did grow, it didn’t grow quickly enough to keep prices stable.

Figure 3. The Next Five Years?

Figure 3 illustrates a future in which world demand has collided with world supply, and then demand growth continues to stay ahead of supply growth. In the world of peak oil, this happens because supply is falling. In the peak lite world, it can occur even if supply is increasing. In the figure, I show an example of supply and demand colliding in 2010, then demand exceeding supply in future years. Of course demand as defined in Economics 101 won’t actually exceed supply, demand will just be destroyed by rising prices (as shown on the right axis) to keep it in equilibrium with supply. Figures 2 and 3 illustrate what Peak Lite is all about; that you don’t have to have falling supplies to start experiencing the effects of peak oil.

I created the original figures in mid-2007, and as we know by mid-2008 oil prices had risen much higher than the $95/bbl I illustrated on the figure. But circumstances have changed. As a result of climbing oil prices, new projects have begun to come online. Strong price signals from the previous five years had resulted in major investments into new oil production (but it takes a few years to bring new projects online); about 5 million bpd of new capacity was expected to come online in 2008 alone.

At the same time, oil prices climbed much too quickly for the economy to even begin to adjust, and this contributed to the overall economic collapse. The combination of high prices and the economic troubles have taken a bite out of demand (at least temporarily). So we essentially find ourselves back in the position of having perhaps three or four million barrels of excess capacity around the world, and oil prices back in the $40’s. Thus I think Figure 4 explains where we are now – and where I think we are headed.

Figure 4. When Do Prices Bounce Back?

In Figure 4, the year 2007 shows a world in which oil is at $80 and the demand has nearly caught up with supply. 2008 shows an example of no spare capacity, and the oil price sharply higher. Then 2009 shows the situation with reduced demand, some incremental capacity increase over 2008 (new projects scheduled to come online in 2009 will generally be too far along to cancel), and the corresponding price collapse arising from the largest spare capacity situation in several years.

So, where do we go from here? I think it depends on how quickly demand bounces back.

The Next Five Years

What might the next five years look like? Do we revert back to Figure 1, in which we see steady prices for years (except this time in the $40 region)? Or do we return to the eroding capacity case of Figures 2 and 3? I have reason to believe the latter is the case.

One reason for this is that the oil industry needs higher prices to warrant new projects. Sig Cornelius, the Chief Financial Officer of ConocoPhillips, recently stated that oil needs to average $52/bbl in order for the company to break even. The cost of finding and developing oil has gone up, and recently Eni CEO Paolo Scaroni said that oil prices would need to be $60 to keep up the needed investments. As a result of low oil prices, drilling rigs are being underutilized and projects are being canceled:

E&P Capital Expenditure Cutbacks

The International Energy Agency estimates that about $100 billion of worldwide oil production capacity expansion projects have been cancelled or postponed over the past half year. According to Barclays Capital, oil companies have cut worldwide exploration and production spending by 18 percent so far this year. Deutsche Bank estimates that U.S. energy exploration-and-production spending will drop $22.5 billion this year, a 40-percent, year-on-year decline.

Saudi Arabia has cancelled the development of several fields such as the Manifa and Dammam oil field, which would have added about 1 million barrels per day (MMBpd) of capacity. Refinery projects have also been delayed or cancelled while Saudi Aramco reviews cost estimates in the light of the significant weakening of oil prices. Saudi Aramco will consider re-issuing a tender for Manifa’s development at a later date, assuming bids from contractors reflect a reduction in raw materials to match lower oil prices.

Such cancellations come at a price, which the article summarizes:

New oil-and-gas projects usually take several years of development before starting commercial production. According to Cambridge Energy Research Associates, the scaleback in exploration and production could reduce future global oil supplies by up to 7.6 MMBpd in five years, or 9 percent of current production. If demand suddenly comes back as it did in 2003-2004, there could be a resulting shortfall of production and much higher energy prices. The International Energy Agency (IEA) also warns that the credit crisis and project cancellations will lead to no spare crude oil capacity by 2013.

The longer oil prices stay low, the worse the shortfall will be due to the project cancellations and increasing demand. Incidentally, these factors also explain a big part of why the oil industry is historically cyclical; in the good times producers spend money, and then when supply gets ahead of demand and the price falls, they slow down on investing. This eventually leads to tightness again, so the good times return. The steepness of the World Oil Price curve in Figure 4 could be much steeper if demand recovers sooner rather than later.

The prospect of sharply higher taxes on the oil industry is a second factor that threatens to slow the development of new oil projects. A recent study by the American Petroleum Institute concluded that this number is “at least” $400 billion over the next 10 years. That seemed quite high to me, so I wrote to the API for a breakdown. Jane van Ryan, Senior Manager of Communications at the API, responded:

The figure is, according to our tax experts, “at least $400 billion” and could be significantly higher.

Using EIA numbers, our tax analysts have examined the impact on the industry of the administration’s cap-and-trade proposal using five scenarios. The results indicate that about 60 percent of the administration’s proposal, which would raise $645.7 billion in “climate revenues,” would be funded by the oil and natural gas industry. This means the industry would pay about $400-450 billion. We have opted to use the lower figure.

The industry’s share of business-wide tax provisions as well as new taxes on the industry are estimated at $80-90 billion over ten years. Again, we have opted to use the lower figure. These tax provisions include the reinstatement of the Superfund Tax, the repeal of the LIFO provision, internal enforcement/reform deferral/related tax reform policies, an excise tax levy on federal offshore leases in the Gulf of Mexico, the repeal of the enhanced oil recovery credit, the repeal of the marginal well tax credit, the repeal of the expensing of intangible drilling costs, the repeal of the deduction for tertiary injectants, the repeal of the passive loss exception for working interests, the repeal of Sec. 199 for oil and natural companies, the increase of the G&G amortization period for independent producers to 7 years, and the repeal of the percentage depletion for oil and natural gas.

While I won’t get into all of the pros and cons of new taxes, higher taxes will provide a disincentive for projects which are projected to have a marginal financial return. If this further contributes to underinvestment, it will worsen the overall tightness in the oil markets, which will put more upward pressure on prices. Thus, high oil prices will likely again be a campaign issue in the 2012 presidential elections.

Conclusions

While the oil industry is historically cyclical, I believe we are approaching the point at which the industry will no longer be able to build out enough new projects to stay ahead of demand. This could manifest itself as peak oil, in which case the rate of depletion permanently overtakes the rate at which new production comes online. Or it could first manifest as peak lite, in which case new production still stays somewhat ahead of depletion, but can’t keep up with new demand. In either of these situations, I think the historical cyclicality of the oil industry will disappear. In early 2008 I thought we had reached that point, but it appears that we had at least one more cycle ahead.

While it is too early to tell with a high level of confidence just where we are on the depletion curve, the summer of 2008 provided of taste of life in an oil-constrained world. The current level of underinvestment and the prospect of higher taxes are setting up another situation in which spare capacity erodes, leading to higher oil prices and greater volatility. Add to this the prospect of a global oil production peak, and I have trouble seeing a case where oil prices will remain stable in the coming years.

As an investor, I use blue chip oil stocks as a defensive measure against much higher prices. I am not one who subscribes to the idea that oil companies are going to be put out of business by running out of oil, or by ethanol, algal biodiesel, or any other combination of alternative fuel technologies. In fact, I strongly believe that if an alternative technology begins to look attractive enough, oil companies have deep enough pockets to shift their business in that direction. But I think that’s unlikely to happen any time soon.

As a consumer, it would probably pay to evaluate just how much higher prices might impact your budget – and then take action. Can you sustain oil prices that return to $150/bbl or more? Even if you can, do you want that uncertainty hanging over your budget? If not, then it would be prudent to take steps to minimize the personal impact of high oil prices. Steps to consider include utilizing more fuel efficient transportation, public transportation, ride-sharing, and if possible locating closer to your place of employment.

Plan ahead and don’t get caught off-guard like so many did last summer. It is only a matter of time before history repeats itself. Here’s hoping our political leaders make policy decisions that won’t worsen the impact.

Tariff Turnabout

This is a timely story, coming on the heels of the previous story on the tariffs the U.S. applies to Brazilian ethanol:

European tariffs stun U.S. biodiesel industry

The U.S. biodiesel industry will suffer from new trade barriers that threaten to end its lucrative export business to Europe, and in Texas the measure could be devastating.

Last week, the European Commission said U.S. biodiesel exporters will now have to pay additional anti-dumping tariffs of up to 29 percent, and anti-subsidy duties of up to 41 percent. The tariffs are temporary for the next six months, but the commission will decide by this summer whether to extend them for five years.

The tariffs came after complaints last year that U.S. biodiesel producers were collecting both U.S. and European subsidies and then selling huge quantities of fuel in Europe at prices that undercut domestic producers.

European officials estimated that 80 percent of U.S. biodiesel production was exported in 2008.

I would suspect that people who might have a problem with their tax dollars subsidizing Brazilian ethanol would also have a problem with their tax dollars subsidizing European biodiesel users. If I am not mistaken, ethanol that is exported loses most of the U.S. tax advantages, hence the incentive is to use it at home. Apparently the biodiesel industry is set up differently with respect to the tax credits.

Credit to KingofKaty for the find.

Trying to Make Sense of Ethanol Tariffs

Note that in the following essay, I am not trying to come down either for or against ethanol tariffs, but rather to discuss what I see as the key issues surrounding them. U.S. energy policy is slanted to favor U.S. farmers and ethanol producers, and I am merely trying to explain the tariffs within that context.

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You are probably aware that the U.S. imposes a $0.54/gallon tariff on ethanol that we import from Brazil. Brazil’s President Luiz Inacio Lula da Silva met with President Obama last week and implored him – in the name of a better environmental policy – to remove the “absurd tariffs on ethanol.” In response President Obama said the situation is “not going to change overnight.”

Brazil wants help lifting US ethanol tariffs

Brazil is a world leader in biofuels and the world’s largest exporter of ethanol. But Silva, who met with President Barack Obama on Saturday, has made little progress persuading the U.S. to reduce the tariffs, which are in place to protect American farmers who make ethanol from corn. Brazil makes ethanol from sugar, in a process that is much more efficient and costs less.

By all accounts, ethanol from sugarcane is a more sustainable model than ethanol from corn. The key to this – as I explained here – is that a true waste product (bagasse) is generated and used to fuel the boilers, mostly eliminating the need for fossil fuels for the production of the ethanol. So why do we penalize Brazilian ethanol? Is it pure protectionism?

While I am no fan of the perpetual subsidies we have put in place to prop up our corn ethanol industry, I think the tariffs do make sense in light of what policy-makers are trying to achieve. Gasoline blenders receive a credit of $0.51/gal (soon to drop to $0.45/gal, which should be this year since the farm bill said the credit would drop “beginning in the first calendar year after the year in which 7.5 billion gallons of ethanol is produced”).

While the credit indeed goes to the gasoline blender, since it reduces their costs for ethanol, it provides an incentive for ethanol producers. That is why ethanol producers – and not gasoline blenders – are the ones who always scream the loudest when the discussion turns to removing the credit. The question on the ethanol tariff becomes “Do we want to extend that incentive to Brazilian ethanol producers?” In other words, do you want your tax dollars going to incentivize sugarcane ethanol producers?

Here is how the tariff prevents that. A gasoline blender could buy corn ethanol or sugarcane ethanol, blend it into gasoline, and get the same blender’s credit in either case. Because ethanol produced from Brazilian sugarcane is cheaper than ethanol produced from corn, without the tariffs in place blenders would likely get all of the ethanol they could from Brazil. Given that this is completely contrary to the goal of creating a U.S.-based ethanol industry, the tariff makes sense in that context. One could argue the point that the tariff isn’t there to punish Brazilian ethanol, but rather to prevent them from taking advantage of a provision designed to spur U.S. ethanol production with taxpayer money.

Of course the fact that the tariff is $0.54 while the blender’s credit was $0.51 and quickly falling to $0.45 is a different matter. If the tariff is equal to the blender’s credit, then indeed one could argue that this is merely the removal of U.S. taxpayer support from Brazilian ethanol. However, if the tariff is greater than the blender’s credit, it begins to look like a punitive tariff, designed to do more than just remove U.S. taxpayer support. There is a senate bill currently under consideration to level that playing field back out:

Bipartisan Senate bill seeks lower tariffs on ethanol imports

A bipartisan group of senators is seeking to lower U.S. tariffs on ethanol imports to achieve “parity” with the blender’s credit, which was reduced in last year’s farm bill.

The farm bill knocked the blender’s credit from 51 cents per gallon to 45 cents per gallon. A new Senate measure (pdf) is aimed at knocking down the 54-cent-per-gallon import tariff and the 2.5 percent ad valorem tariff to achieve “parity” with the lowered blender’s tax credit.

Sen. Dianne Feinstein (D-Calif.), one of the sponsors, said in a statement that the higher import tariff creates a barrier for sugarcane-based ethanol from Brazil, and hence gives gasoline imports a “competitive advantage.”

I don’t find myself agreeing with Senator Feinstein very often on energy issues, but here I think she is correct. This is the other side of the coin. While the tariff may have the effect of ensuring that the blender’s credit only goes to U.S. ethanol producers, it also has the impact of putting Brazilian ethanol at a competitive disadvantage to gasoline or crude oil imports. Is this desirable? I don’t think so. To the extent that we require fuel imports, I fall into that camp of preferring to deal with Brazil over Venezuela.

So, how might I write a better policy than the one we have now but still protect U.S. ethanol producers? First, eliminate both the blender’s credit and the tariffs. This removes the barriers to Brazilian ethanol, while leveling the playing field with gasoline imports. Second, given that the present policy is designed to protect U.S. ethanol producers, require that some percentage or some volume of ethanol blended into the fuel system must come from them. Third, even with the current blender’s credit in place, U.S. ethanol producers are struggling to survive. If they had to sell their ethanol in a competitive (unprotected) market, they would all go bankrupt. Therefore, you have to keep the mandates in place regarding the amount of ethanol that must be blended into the fuel supply. This ensures that even if they can’t compete in an open market, they still have a captive market.

Of course I have said many times that I don’t favor mandates at all, nor do I think the corn ethanol industry will ever be viable in an open marketplace. However, it would be disastrous for Midwestern economies to completely pull support from under the industry. I would favor a policy in which we no longer encourage expansion of the industry, and over time phase the mandates out. This would in my opinion be the end of the corn ethanol industry, but a slow end without a shocking impact. If it isn’t, and they can survive in a world without mandates, then more power to them. But if they still can’t manage to live without subsidies after receiving them for 30 straight years (and even that wasn’t enough, hence the mandates), why should we expect that they ever will?

Incidentally, one final note on Brazil. People sometimes ask me which countries I think have a bright future, despite the prospect of peak oil. I think it is hard to make a case that anyone is going to be better off than Brazil. They are sitting on top of huge oil reserves, they can produce ethanol very efficiently and have the infrastructure in place to utilize it, and they have good solar insolation for solar panels, solar hot water, etc. I just don’t know of other country as well-positioned as they are. Not only do I think they will survive peak oil, I think they will thrive and their economy will continue to grow. That’s just one of the reasons I have invested money in Brazil.

Valero Now in the Ethanol Business

In an update to Big Oil Buys Big Ethanol, it is official:

Valero Energy, the Oil Refiner, Wins an Auction for 7 Ethanol Plants

Valero Energy, the country’s largest independent refiner, said on Wednesday that it would buy seven ethanol plants from VeraSun Energy for $477 million, giving the biofuel industry a lift at a time when it is suffering from excess production capacity and falling gasoline consumption.

VeraSun, the nation’s second-largest ethanol producer after Archer Daniels Midland, filed for Chapter 11 bankruptcy protection last fall. Valero’s purchase signals important new support for a flagging industry from an unexpected quarter. In recent years, refiners have opposed Congressional mandates for refineries to blend increasing amounts of ethanol in gasoline, arguing that it made neither economic nor environmental sense.

So, for the price of $477 million, which would be less than 5 days of profit for someone like ExxonMobil, you can be the 2nd largest ethanol producer in the country. Even for Valero, $477 million is a piece of cake. Like I say, people who think the ethanol industry is a threat to the oil industry don’t understand the difference in scale between the two. If ethanol starts to look like a good business model, the oil industry will buy up the assets without breaking a sweat. The first salvo has been fired.

The Oil Industry Helps Bail Out AIG

OK, maybe that’s an exaggeration. But they did just chip in close a billion dollars to the government coffers that are propping up AIG:

US Central Gulf Lease Sale Bids Total $703 Million

HOUSTON -(Dow Jones)- U.S. Interior Secretary Ken Salazar said the Central Gulf of Mexico Oil and Gas Lease Sale 208, held Wednesday in New Orleans, attracted more than $703 million in high bids.

The sale was conducted by Interior’s Minerals Management Service, or MMS, and had 70 companies submitting 476 bids on 348 tracts comprising over 1.9 million acres offshore Louisiana, Mississippi and Alabama.

However, that amount was lower than last year’s take (also a small fraction of the size of the AIG bailout):

The total amount of money that MMS would collect from this Central Gulf Lease sale is lower than last year, which attracted 78 companies and collected a record $3.7 billion, amid booming prices for oil and gas.

Given that we are now into AIG for $170 billion, another 242 successful auctions like the one yesterday and the AIG debt will be covered. Of course that’s assuming we aren’t soon out another $170 billion, and the oil industry hasn’t been taxed out of existence.

A Lost Litigation Opportunity

While the so-called ‘hot gas’ issue has been discussed here several times before, there are new developments out in California that have Oil Watchdog and the $295/hr lawyer behind this ‘consumer organization’ crying over lost litigation opportunities. Given the time, effort, and money they have put into this issue, the events described in this essay are quite a blow for them.

At least they will now have more time to devote to their other campaigns, such as 1). Stopping oil companies from donating money to universities; and 2). Berating oil companies for not giving enough to universities. (They make more sense if you view them as a satirical site along the lines of The Onion. The only problem is that Oil Watchdog is trying to be serious). I think it is particularly curious that the press uncritically accept and quote those associated with Oil Watchdog as consumer advocates trying to do the right thing by consumers, when a cursory investigation would show what they are (hypocritically) up to.

First, here are a few of the links to previous discussions of the issue:

Hot Gas Lawsuit in Utah

More on Hot Gas Lawsuit

Hot Gas Issue Heating Up

Hot Gas is a Bunch of Hot Air

In a nutshell, the issue is that gas expands when the temperature is warm, and so a gallon of ‘hot’ gas has less energy than a gallon of cooler gas. This means you aren’t getting the same amount of energy from your gasoline that is hot, therefore “you are being ripped off.”

This is the kind of issue that an organization like Oil Watchdog was built for. They can hype up the controversy, get outraged people to send them donations (after all, who is going to protect the little guy from Big Oil if not them?), and try to get some litigation going to benefit people like the professional litigator who is behind the site. His own website says that he “has focused on suing insurance companies that overcharge or mistreat consumers, in violation of state laws; cell phone companies for billing mistakes and poor service; and HMOs and health care companies for providing shoddy health care and refusing to pay people’s claims.” Just imagine the potential windfall if he can get a class action going by convincing enough people that deep-pocketed Big Oil is overcharging and mistreating them. That would certainly earn him more money than 99.99% of the “greedy” people in the oil industry.

Oil Watchdog – a spin-off of the Foundation for Taxpayer and Consumer Rights (see this story for the dirt on why they do what they do and evidence of who is behind the site) – has fought to force installation of temperature compensating equipment so that the gallon is corrected for temperature. That means when the gas is warm, you get a little more than a gallon, but when the gas is cold you get less. So what’s wrong with that? Basically, as I discussed at the links above, it belies a real misunderstanding of just what the outcome would be.

Imagine for a moment that you redefine a gallon so that the new volume is now equivalent to 1.5 of the old gallons. Do you think the price for a gallon of gasoline would stay the same? Of course it wouldn’t. You would pay 1.5 times as much for it. This is what Oil Watchdog and others pushing for this legislation could never absorb: It wasn’t going to work as they claimed, because as soon as the size of the gallon changes (which is what temperature compensation does), the price will change. You would probably find more variation in energy content just based on how the gasoline is blended. (Imagine how outraged they will be when they finally figure out that ethanol is contributing to gasoline with lower energy density, or that energy density varies between summer and winter.)

Oil Watchdog has really been on top of this issue, issuing press release after press release to make sure everyone knew how badly consumers were getting ripped off. Yet despite all that effort, the California Energy Commission has ruled against them:

Commission says fixing ‘hot fuel’ would drive up fuel prices

This is of course what I have been saying since this issue first cropped up. From the article:

The California Energy Commission says forcing retailers to install temperature-compensation devices on fuel pumps would drive up the price.

Officials with the Owner-Operator Independent Drivers Association challenge that claim, saying a one-time investment by fuel companies is part of doing business and would save consumers money in the long run.

During a business meeting Wednesday, March 11, the California Energy Commission recommended against forcing retailers to implement automatic temperature compensation, or ATC, at the pump.

Retail fuel is currently sold as a 231-cubic-inch gallon and does not take temperature into account. Elementary physics shows that all liquids expand and contract with temperature changes.

State and federal law does not require fuel retailers to compensate for temperature, but consumer groups and some lawmakers are trying to change that.

Directed by state law AB868, the California Energy Commission studied fuel temperature and evaluated the cost of implementing ATC at retail pumps.

“If retail station owners and operators continue (are) to grow and remain profitable, then retail station owners will most likely raise their fuel prices to compensate for selling fewer ‘gallons,’” commissioners wrote in the report. “If this is the case, then expected benefits for retail motorists will be essentially zero.”

Oil Watchdog of course wasn’t going to take that lying down, so they have issued a series of press releases charging conflicts of interest and anything else they think will stick (and draw attention away from all of their donors’ money they wasted on this). Here was their latest press release on the issue:

Documents Show Political Appointees Interfered With Cal. Energy Commission Study Of Hot Fuel Ripoff To Protect Oil Companies

Personally, I think that’s too subtle, but what do I know? I am not an ace journalist like the staff at Oil Watchdog.

As I have documented previously, Oil Watchdog started censoring comments following their stories because people were consistently demolishing their claims. Some of the comments are very good, though. So below I have copied one of those comments that Oil Watchdog conveniently put out of sight by default (and you will see why they started doing that). This is a typical sort of blistering rebuttal they often receive following some of their hysterical “essays”, which finally resulted in them frequently labeling those who disagree with them as “Shills for Big Oil.” What else were they going to do, debate the technical merits?

It is a bit long, but a highly entertaining example of what happens when an organization completely devoid of any technical people on their staff pumps out the misinformation they do. As the poster below points out, there seems to be no due diligence at all, but the reason for that becomes clear when one understands their actual objectives.

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Oil Watchdog presents the hot fuel issue as one hoisted on the public by Big Oil. Without defining Big Oil, we have to assume she [Judy Dugan] means large refiners and integrateds, as opposed to retailers. Let’s examine the facts in this case, instead of the anecdotes.

The claim is that an annual $400,000,000 in excess revenue is generated dishonestly in California. As Oil Watchdog is clearly biased in this case (they are after all paid to criticize the oil industry), we can safely assume that this figure is probably at the very highest end of the impact spectrum. But let’s take it anyway, and break the figure down and see, to a reasonable approximation, just who is getting what from hot fuel. By the way, I’ll state here that the more accurately fuel can be dispensed, the better for consumers. But the real issue is, not what is the best technical solution, but whether consumers would benefit from ATC. Oil Watchdog sweeps the latter point under the rug and presents ATC purely as a morality play.

The simple analysis goes as follows:

$400,000,000: Oil Watchdog’s claimed ripoff. This is in the form of revenue to the retailers.

10% profit margin: we are here mixing refiners and integrateds, so it’s not a bad approximation. But we’ll reach the same conclusion below with any reasonable range of profitability assumptions.

$40,000,000: hot fuel profit to the industry.

Who is getting this? We know it only applies to the retail level (as Dugan has reported herself) since refiners sell their fuels corrected for temperature.

Here are the market shares of California refiners, as reported by the state of California:

Company CA Market Share, Gasoline
BP 19%
Chevron 19%
Valero 13%
ConocoPhillips 12%
Tesoro 11%
Shell 10%
ExxonMobil 6%
Big West 2%
Kern 1%
New West 1%
Petro-Diamond 1%
Tower Energy 1%
IPC 1%
Others 3%

In terms of industry concentration, this market does not look particularly concentrated when compared to other critical industries, such as automobiles, computers, or tires. So the case for conspiracy is weak on the basis of market share alone. At the level of the state of California, the Herfindahl Index for refining would be about 1300, well below the 1800 that might start getting attention at the Department of Justice. In fact, the DOJ considers industries in the range of 1000 to 1800 as being only “moderately concentrated.”

We now want to take the $40,000,000 hot fuel profit derived above, and allocate it to the state’s refiners. But first, as Dugan knows and has reported, we know that Big Oil has largely exited the retail sales business. In fact, she has quoted the widely published fact that about 97% of retail sales go to retailers, and not to Big Oil. So we need to allocate 3% of the $40,000,000, or $1,200,000, to Big Oil refiners by market share. When we do that we get the table below (here showing Big Oil shares).

Company Share of Hot Fuel Profit
BP $228,000
Chevron $228,000
ConocoPhillips $144,000
Shell $120,000
ExxonMobil $72,000
Combined Retailers $38,800,000

Clearly, the benefit to Big Oil, by Dugan’s own figures, of hot fuel in California would not even cover the cost of a lawyer for each company. In short, Big Oil could really care less about hot fuel in terms of impact to the bottom line. ExxonMobil’s hot fuel take in California represented about 0.00018% of its total profit. It probably spends many times that on landscaping or office water coolers.

And just as clearly, we see that the retailers should have a vested interest in the outcome. But when you consider that there are about 12,000 gas stations in California, you find that

$38,800,000/12,000 = about $3200 annual hot fuel profit per gas station.

In other words, the average California station doesn’t appear to be getting a huge jolt from this either. I think we can safely assume that this is not a profit grab by Big Oil, or even the retailers: the retailer opposition is probably based more on avoidance of ATC costs and maintenance.

But the really interesting point to be made here is that on the one hand Oil Watchdog charges this group of retailers with fraud, but on the other hand claims that the retailers will now absorb the cost of the equipment and maintenance, to the benefit of consumers. What if Oil Watchdog is wrong, and the consumers end up behind in the long run? This strong possibility is essentially ignored. For reference, the average consumer, if he drives 15,000 miles per year and gets 20 mpg, is paying a little under $19 per year on hot fuel (based on the $400,000,000 divided by gallons sold in California, or 2.6 cents per gallon). What if the retailers pass along an average of 4 cents per gallon? Why not? Aren’t they conspiring to rip us off now anyway? After all, each retailer will know that his competitors are facing the same new expense. The whole episode would probably be a futile exercise in money laundering in which no one benefits. This is one of the reasons why the American Trucking Associations, the nation’s spokesman for the trucking industry, opposes ATC. Any charge that the ATA has a vested interest in higher fuel prices is not credible.

If the potential buyer of Judy Dugan’s $5000 used car finds a defect in the engine (perhaps a microscopic hole in a piston) that might cost him 8 extra gallons of gas per year (near our $19 hot fuel cost), and Dugan learns it will cost $500 to replace the piston, will it be a good thing for the buyer if she does that and charges him $5500? Dugan is, after all, selling a car which she knows has a hidden foot on the gas pedal. Or would she just negotiate a new price and let the market make the correction? Isn’t that in fact what retailers are doing? As the market shares above show, and as recent steeply falling gasoline prices have proven, the industry is competitive. Unless they conspire, it would seem that no one retailer could make incremental profit off hot fuel as long as a competitor somewhere was willing to cut into that profit to gain market share. The market will equilibrate to a rate of return acceptable to competing retailers. Introduce a retail cost perturbation into the system, as in ATC, and prices will tend to adjust to maintain that equilibrium margin, unless one believes that the retailers will now stop ripping us off and simply accept lower incomes.

One gets the sense that Oil Watchdog does not understand the concept of cost-benefit analysis, and instead subscribes to the simple belief that anything bad for the oil industry must be good for consumers. The representation of hot fuel as a willful fraud perpetrated by Big Oil, when Oil Watchdog has acknowledged that refiners deliver temperature corrected fuel to retailers, is negligent and cynical…. or just plain dishonest. There is an underlying perception that this issue is one of self-interest for Oil Watchdog, a feather in their cap so to speak, or perhaps justification for existence in a world where the recent steep drop in prices prove that oil companies cannot set those prices, thus muting many of Oil Watchdog’s past charges. The rug being pulled from under its feet, Oil Watchdog needs a new pretext for its sources of funding.

Now, Oil Watchdog may in fact be correct on this issue. There is a lot of uncertainty in the data and therefore conclusions on hot fuel cost estimates, and future market responses to ATC installation cannot be predicted with certainty. But they make no credible case, and reasonable calculations based on their own numbers raise legitimate doubts as to who really benefits. Unfortunately, instead of pursuing an impartial quantitative analysis, they turn ATC into a witch hunt and go after the usual suspects. Their motivation appears above all else to be giving the oil industry a black eye; consumer benefit is assumed, and not investigated. The possibility that they could be wrong, and therefore that they could be hurting consumers, takes a back seat. There does not appear to be any due diligence on Oil Watchdog’s part to demonstrate that their position on ATC would result in a net benefit to consumers.