Energy, Security, and Climate

Nate Silver’s new FiveThirtyEight has been catching a lot of flak since it launched last week. Perhaps the harshest has been directed at the site’s retention of the often-contrarian climate analyst Roger Pielke Jr., with everyone from Paul Krugman to the Center for American Progresspiling on. The onslaught is disturbing. I’ve disagreed with Roger often, but he is genuinely well intentioned. People who care about getting good policy should want more thoughtful voices, not fewer, proposing options – and organized campaigns to run heterodox thinkers out of town are awfully ugly. But that doesn’t mean I’m impressed with the new FiveThirtyEight. Indeed it’s another energy post – “U.S. and Chinese Current Accounts Converging” – that’s troubling. The post starts out with an arresting chart (reprinted at the top of this post) that shows an impressive improvement in the U.S. current account balance. The author then explains what’s happened: “In the U.S., a natural gas boom is cooling demand for imported petroleum, and oil represents a huge share of American imports. The dollar, meanwhile, has depreciated, boosting American exports.” This is certainly the conventional wisdom. But what one expects from FiveThirtyEight is a data-driven interrogation of that conventional wisdom. Alas that would have produced a different result. Here’s another chart that combines the data presented by FiveThirtyEight (the blue line – it looks different because I’m showing absolute numbers rather than percentage of GDP) with three other series. Start by comparing the blue and red lines. These seem to move together beginning in 2009. In particular, what you’ll see is that the big shift in the current account comes in 2008-9. Indeed the decline in the oil trade balance (the red line) accounts for a little more than half the decline in the current account balance. So far so good: changes in oil trade seem to explain a lot of what’s happening with the current account. But now look at the dashed lines. The green dashed line shows that net petroleum and product imports have been declining steadily since about 2007. This raises a first problem with FiveThirtyEight’s analysis: if falling oil imports explain so much of the lower current account deficit, why hasn’t the current account deficit continued to plunge alongside oil imports? The answer is pretty straightforward: oil prices have gone up. The United States imported 64 percent as much oil in 2013 as in 2009, but the average cost of an imported barrel was 66 percent higher. It’s the purple dashed line, though, that’s the most damning. What that line shows is that in the span that the U.S. current account balance really shifted – 2008-9 – U.S. oil production had barely begun to pick up. It was only later, beginning in 2011-12, that output really took off. But that’s not the period when the big change in the current account balance appeared. (Had I added in natural gas liquids, which started rising earlier, the comparison would look a little better, but the basic problems would remain.) Had FiveThirtyEight actually juxtaposed the current account balance with oil trade data, it wouldn’t have ratified the conventional wisdom. Indeed one shouldn’t be surprised with this result. As Robert Lawrence showed in a paper that my program published in January, there are strong theoretical reasons to be skeptical of claims that falling U.S. oil imports and rising U.S. oil production will substantially reduce the U.S. current account deficit. Which gets to the heart of FiveThirtyEight’s challenge. They want to do theory-free data analysis. But without at least some sort of theory, you at best need to investigate a much larger volume of data in order to get useful results. (That’s what Nate Silver did so well with election predictions and baseball statistics.) At worst, if your data isn’t good enough, theory-free analysis leaves you with nothing. Here’s hoping that FiveThirtyEight will be disciplined enough to stick to analyses where its unusual approach works.

As the standoff between Russia and Ukraine drags on, there are increasing calls to use U.S. oil and gas exports to weaken Vladimir Putin’s hand. There’s something to this, but it’s likely to be a lot less powerful than most pundits seem to think. Europe imports about thirty percent of its natural gas from Russia. Russia could, in principle, cut off some or all of that supply. That prospect presumably makes European leaders less willing to take strong positions against Russia in its confrontation with Ukraine. People have argued that boosting U.S. natural gas export capacity (or, more precisely, changing policy to make that more likely in the future) could do two things. First, in the current crisis, it could deter Putin from using the gas weapon, lest he encourage Europeans to make concerted efforts to shift their long-term gas procurement to the United States when that becomes possible in a few years. Second, in future crises, it could blunt the Russian gas weapon, since U.S. exports would be available to fill in for Russian supplies. (You might have noticed that I haven’t said anything about oil. That’s because the idea that U.S. oil exports would give Europe some sort of special buffer is silly. The world oil market is pretty flexible, and U.S. exports would be a drop in an already large sea. To the extent that Europe is constrained in its ability to switch oil sources quickly, that’s because of infrastructure, something U.S. exports wouldn’t change.) There are two essential things to keep in mind when thinking through the claims about natural gas exports. First, decisions about whom to export to and import from are made by commercial entities, not by governments. When a U.S. analyst says, “we should tell Europe we’ll sell them our gas”, the first response should be, “who’s ‘we’”? (The second response should be, “who’s Europe?”) The U.S. government doesn’t get to sell gas to anyone; it can create a framework in which commercial entities can sell gas, but after that, it’s up to those businesses to decide where the gas goes. Similarly, “Europe” doesn’t buy gas – all sorts of European companies do, within European and national regulatory frameworks. Second, surging natural gas into Europe to respond to a crisis requires that there be infrastructure in place that can accommodate that surge. In the case we’re talking about here, that means having a bunch of unused (or partly used) European natural gas import terminals that can suddenly absorb newly arrived U.S. supplies. And remember – back to the first point – these terminals will be built by private players. So what does this all mean for the big strategic claims? It is difficult to see how U.S. exports will substantially erode the long-run share of Russian gas in Europe. It is far more profitable for buyers of U.S. natural gas to ship it to Asia – where prices are far higher – than to Europe. (The exception is if European companies are willing to pay a hefty premium to get their gas from the United States – but remember, these are commercial entities, which makes it very difficult for them to do that.) There is, of course, a knock on effect from that, since if U.S. gas frees up other supplies that were destined for Asia, those supplies can potentially move into Europe instead. But Russia remains a relatively low-cost supplier into Europe, and can trim its prices to keep its market share. Moreover, unlike European gas companies, the big Russian players have much tighter ties with the state. If Moscow wants them to keep their share in the European market for strategic reasons, it may be able to make them do that. Russia would lose money – an important piece of geopolitical harm – but its leverage wouldn’t be slashed. What about supplying gas to Europe in a crisis? Here the basic constraint is infrastructure. Gas demand is seasonal, so during some parts of the year, there may be underutilized LNG import terminals. [UPDATE 3/6: Moreover, with a weak European economy, there is currently a lot of unutilized European LNG import capacity year-round; whether that persists indefinitely remains to be seen. Even in the current case, though, Russian imports into Europe greatly exceed spare LNG import capacity.] Were Russia to cut gas supplies to Europe during a crisis, if prices rose high enough, those terminals could be used to surge in some supplies. During other times (notably winter, when gas demand is most acute) the terminals will be fully utilized, making them unavailable to bring in new LNG supplies. The only way around that is to overbuild. This might happen by mistake, but unless European policymakers offer financial incentives, profit-seeking firms won’t do it on purpose. There is one other wrinkle worth thinking about here. The United States is currently able to take a harder line against Russia than Europeans are in part because the U.S. economy is insulated from energy-related turmoil. Were the prospect of surging gas into Europe a real one, we’d be having all sorts of debates here about the economic fallout for the United States from escalation with Russia. [UPDATE 3/6: It’s worth distinguishing here between swinging U.S. gas from Asian to European customers, which wouldn’t affect the U.S. market, and boosting total U.S. exports, which would.] Ironically, while being more connected to European gas markets might give the United States more tools in a future crisis, it could also deter Washington from aggressively confronting Russia.

The current Economist has an article on U.S. oil and gas that repeats an increasingly common view: tight oil will make “future oil shocks less severe” since “frackers can sink wells and start pumping within weeks”. (Here’s a variant from The Atlantic last August.) That speedy response means that “if the oil price spikes, [drillers will] drill more wells”, quickly spurring new production, and taming any price spike. This is severely flawed – a point that recent experience reinforces. It is undeniably true that the time from drilling to production is far lower for tight oil than for traditional wells. But that doesn’t mean that industry can respond quickly and powerfully to oil market shocks. Imagine that a disruption in the Strait of Hormuz threatened to send oil prices up from one hundred to two hundred dollars a barrel for a span three months. How would U.S. oil producers respond? The first thing they’d do is ask themselves whether new investment would make sense over the full life of any new well rather than just over the span of the disruption. Let’s take a best-case scenario: a developer realizes that something is afoot on Day 1 of the crisis and is confident the price rise will last three months. If you assume that about 20 percent of a well’s output comes in its first year, and that production declines by about 50 percent in a straight line over the course of that year, then you end up with 6-7 percent of total production during the period of elevated prices. Wells with break-evens up to 106 or so dollars a barrel, rather than merely 100 dollars a barrel, are now in the money. This will not spur radical change. (If I was doing this carefully, I’d discount future cash flow, making the up-front revenue boost more consequential. But the basic qualitative point would still stand.) Even if you extend the crisis to six months, you get a maximum break-even of about 112 dollars a barrel, a relatively small increment. And this assumes that drillers act instantly upon a supply disruption; in reality, making a decision to drill, mobilizing resources to begin production, and actually drilling and fracking a well would delay the start of production and further blunt the slightly-above-normal returns. One can argue with the numbers I’ve used to make this point, but the basic qualitative conclusion is solid. In fact the numbers I’ve just presented overstate how strong drillers’ response would be. In the short run the number of rigs available for drilling is fixed. (I could make a similar argument about other capital and people needed to initiate production, but it’s useful to focus on one thing.) It’s true that producers can move rigs from natural gas toward oil, but that’s happened so much over the last couple years that there isn’t a huge margin to do that today. Over time, you could see more rigs get ordered. But companies aren’t going to order a bunch of rigs that will be active for a few months and then sit idle once prices return to normal – that’s not a profitable proposition. Instead companies faced with an impending price spike will bid for a fairly fixed set of rigs. Since those rigs are newly valuable – you can now make a bit more money using each one because oil prices are higher – companies will be willing to pay more. The break-even price for a given well will therefore rise, moving some seemingly profitable but marginal prospects back into the red, and leaving them untapped as a result. This dynamic also explains why newly cash-flush producers won’t be able to blindly plow all their money back into increased production even if they were inclined to: the necessary rigs wouldn’t be there. And there’s one more constraint: transportation. Even if drillers can respond quickly, that doesn’t mean that they can get the oil they produce to market. If there isn’t sufficient pipeline or rail capacity to quickly move newly produced oil to market, companies aren’t going to produce that oil. It takes a decent amount of time, of course, to expand transport capacity. This won’t always be a big constraint, but it’s one more strike against the “tight oil production is always going to be super-responsive” line. We’ve recently had an ugly piece of real-world experience in natural gas that backs this all up. Henry Hub natural gas prices rose from $4/MMBtu to about $5.50/MMBtu over the span of a few weeks in January. They’re still elevated. So are rigs rushing toward newly profitable opportunities in natural gas? Absolutely not: the gas-directed rig count declined 4 percent last week (half those rigs went to oil and the other half were inactive) and has fallen 20 percent over the last year. This is due in part to the fact that the cold snap driving prices up right now is ultimately going to dissipate, and in part because we don’t have the right infrastructure in place to move additional natural gas production to market quickly. (It’s also because using available rigs to drill for oil remains more profitable than moving them to gas, despite the price spike.) To be certain, this story would look different if we were talking about long-term increases in the price of oil. A run-up like the one we saw in the 2000s, which unfolded over the span of almost a decade, would give drillers plenty of time to respond. (Though experience in the oil sands in the 2000s suggests that capital and labor constraints – and resulting cost inflation – would still be a major drag.) But for the sorts of oil price spikes we worry about most – those driven by sudden and intense geopolitical disruptions – the responsiveness of tight oil production is likely to do a lot less to blunt the consequences than many people seem to hope.