Fossil Fuels

The Wall Street Journal delivered some disturbing news yesterday: South Korea “sharply boosted imports of Iranian crude” in April, buying 42 percent more than a year before, and 57 percent more than in March. Analysts have speculated as to whether Seoul was attempting to sneak in extra oil before European sanctions begin to bite. A more careful look at the data, though, suggests that the spike in Korean imports is less peculiar than meets the eye. Oil imports naturally fluctuate from month to month. The big question, then, is how anomalous the jump in Korean imports from Iran is. The figure below shows monthly Korean oil imports from Iran going back five years (all data in this post is from Korean customs). It is clear that month-to-month import levels are volatile. The next figure plots absolute month-to-month changes in Korean oil imports from Iran. One can immediately see that there are several other month-to-month changes that exceed what happened between March and April 2012. We can quantify this: the average month-to-month change is 1.7 million barrels, with a standard deviation of 1.2 million. The upshot is that we should expect to see a month-to-month change of at least 2.7 million barrels – i.e. what we saw from March to April – about twenty percent of the time. If we look only at jumps of 2.7 million barrels or more, we should expect roughly one a year. One can, however, ask the question another way. South Korean imports from Iran have been on a downward trend. April imports, then, should have been lower than March ones. Working from this baseline, the actual April figure looks like a bigger jump. I looked at the absolute difference between monthly oil imports and what one would have expected had the previous six months’ trend held up. Korean imports in April now look a bit more anomalous. Had imports followed their six month trend, we’d have expected them to hit 3.4 million barrels in April; instead, they clocked in at 7.5 million. Our data suggests that this sort of aberration should happen four percent of the time, or once every two years. There’s a risk in doing too many statistical analyses (one of them will invariably deliver a phantom result), but let me give you one more way of looking at the trend. Korean imports from Iran dropped by four million barrels between September 2011 and March 2012, or about 700,000 barrels a month, before rising by 2.7 million barrels between March and April. That jump, then, was four times the monthly trend, in the reverse direction. That looks big, but it turns out to be pretty common: it occurred in 20 of the preceding 53 months. The big test will be what happens in May and June. The Korean government announced earlier today that it expects to report that imports decreased in May. If it does not, and imports stay high, it will be much more difficult to dismiss the April data as an anomaly. After all, very loosely speaking, the odds of something that happens four percent of the time happening twice in a row is about one in five hundred.  If imports do drop, though, the current kerfuffle should go away. But be warned: normal statistical noise means that this sort of scare will be repeated as the sanctions continue. Better and more timely data, along with a clear sense of what constitutes an acceptable import pattern, would go a long way to keeping the sanctions on track.

The public battle over fracking tends to emphasize extremes: some say that shale gas can’t be developed safely; others say that new regulation would kill the industry. But a third set of observers (myself included) has claimed that smart new rules would boost costs only marginally, while building public acceptance for drilling. A new study from the International Energy Agency (IEA) adds serious support to this middle way. The study, “Golden Rules for a Golden Age of Gas”, is worth reading in its entirety – it’s a great assessment of the environmental challenges involved in developing unconventional gas and of ways to address them. What jumps out at me, though, is how the authors have gone beyond the usual hand-waving claims about how steps to ensure safe drilling shouldn’t be too expensive. Instead, they’d actually done some concrete cost estimates. The verdict? Adopting “Golden Rules” for shale gas development would add a mere seven percent to the cost of each well. And though the IEA report doesn’t discuss this the impact on the price of gas, at least in the United States, would be even less, because some of the cost of delivered gas has nothing to do with well expenses: distribution costs, for example, would be unaffected by new drilling rules; severance taxes and impact fees wouldn’t change; and corporate taxes would presumably fall a bit, since many compliance costs could be written off. If you think that delivered gas will ultimately cost five dollars for a thousand cubic feet, the IEA is saying that its golden rules would add less than thirty-five cents. Contrast that with the much bigger impact of a backlash against drilling, and you have a pretty compelling case. So what do the IEA “Golden Rules” entail? Some extra spending on “cement design, selection and verification”, together with a bit of extra drilling time to make sure that things are done right. Green completions would be required to avoid flaring and venting. Green fracturing fluids and rock solid treatment of produced water would protect groundwater resources. The IEA even includes costs for soundproofing rigs and implementing some trucking restrictions in order to reduce noise pollution. The authors indicate that this suite of measures is an upper bound on the costs of a smart environmental approach. They observe that large-scale development creates additional ways to improve environmental performance while actually reducing costs. Economies of scale, for example, can make better water infrastructure make simple economic sense, reducing truck trips and improving safe disposal. “Systematic learning” about shale areas can reduce the number of dry wells and unnecessary fracture stages, improving economics while reducing environmental footprints. All told, the authors estimate that these and other steps could cut costs by five percent. In case you’re keeping track, that’s a net impact of two percent on production costs for large-scale development. The IEA estimates, of course, are extremely crude. It wouldn’t be surprising to see compliance costs twice what they estimate – or half. Either way, the bottom line remains: smart regulation of shale gas looks like it would be relatively cheap. It’s the excessively hands off approach that could turn out to be a lot more costly.

It is nearly impossible to read a pitch for expanding U.S. oil and gas production without being confronted with impressive estimates of how many jobs it will create. Wood Mackenzie has estimated that expanded oil and gas production could support 1.4 million new jobs by 2030. Citigroup has claimed an upside potential of as many as 3.6 million jobs from new oil and gas production by 2020. So I was surprised when I stumbled across this promise on the website for American Shale Oil (AMSO), which hopes to develop a commercial shale oil plant in Colorado: Even at commercial stage, the AMSO process is estimated to require approximately 300 employees (to support a 100,000 barrels per day plant). This isn’t a boast about how AMSO will create 300 jobs – it’s a promise that it won’t create any more. What gives? Many of the biggest prospects for U.S. oil development are in remote or low-population parts of the country that fiercely protect their way of life. They’re often thrilled to have development that lets local people find jobs, but they aren’t looking for a big influx of new workers who would fundamentally change their communities. Take a look at North Dakota, the poster child these days for the wonders that oil production can do to combat unemployment. In 2006, right before the shale oil boom started, the North Dakota labor force numbered around 360,000. Had the state followed the rest of the country, it would have had unemployment around 8 percent, and about 30,000 people would have been looking for work. Instead, its unemployment rate is closer to 3 percent, and its labor force now totals 390,000 people, meaning that nearly 380,000 people have jobs. This suggests something striking: even had every one of those 30,000 people found a new job because of the oil boom, North Dakota would still have had to import more than 20,000 workers to meet demand. This sort of change can be enormously disruptive, particularly to those incapable of working in or profiting from the industry. Here’s some context: North Dakota has a population of 680,000; the biggest city even remotely near the oil fields has population 60,000; and the tenth largest town clocks in at a tiny 7,800 residents. There’s little reason to doubt that many North Dakotans would have actually been much happier with a boom that delivered half as many jobs, though there are, of course, many others who would be thrilled to see employment expand even more. It shouldn’t be surprising, then, to find that people in would-be oil producing areas like northwestern Colorado have mixed feelings about big employment gains from new oil production. It’s important to keep this in mind when thinking through the forces that might shape future development. American Shale Oil promises that its “ unique process will not strain the local infrastructure”. There’s good reason to believe that it understands the complex politics of job creation better than some industry boosters in Washington do.

The Fed has a dual mandate to promote stable prices and maximum employment.  With current inflation near the Fed’s long-run target of 2% and unemployment well above estimates of its “natural rate,” Fed chairman Ben Bernanke and NY Fed President William Dudley have understandably stressed their commitment to the second part of the mandate.  Indeed, the Fed’s recent pledge to hold interest rates near zero through 2014 reflects their concern that unemployment will only decline slowly in the coming years, unlike in previous recoveries.  Dudley has stressed the post-crisis decline in the labor force participation rate (LPR) in support of this view: had the LPR not, he said in March, “declined from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.” The implication is that the current unemployment figures present too rosy a picture of the state of the labor market.  Upward pressure on the unemployment rate will emerge as the LPR returns to normal. We think Dudley’s analysis is flawed.  As the large figure above shows, today’s LPR is precisely where its post-2001 trend line suggests it should be. There has indeed been a sharp decline in the LPR since the crisis, but this has merely erased the pause over the four years prior to the crisis, which was driven by robust demand for workers during that period—illustrated in the small upper right figure on unit labor costs. But the broader picture is one of a steadily declining LPR as the population ages, illustrated in the small lower left figure. In short, if the Fed pursues its low-rate pledge with the expectation that the LPR will naturally return to 2007 levels it is likely to underestimate inflationary pressures coming from an improving labor market.  It will therefore hold rates too low for too long. Dudley: The National and Regional Economic Outlook Macroblog: A Take on Labor Force Participation and the Unemployment Rate Talking Points Memo: Why Labor Force Participation Does and Doesn't Matter Real Time Economics: Fed Debates Falling Labor Force Participation

The boom in U.S. oil and gas production has sparked talk of a manufacturing renaissance. I mentioned that somewhat skeptically last week in the context of a much broader piece on the excitement surrounding surging U.S. oil and gas output. I want to drill down on five important issues here. Some of this thinking is preliminary, so as always, feedback is most welcome. Energy is of marginal importance to most manufacturing. Most U.S. manufacturing is not energy intensive. Joe Aldy and Billy Pizer reported in a 2009 paper that only one tenth of U.S. manufacturing involved energy costs exceeding five percent of the total value of shipments. These industries – the most prominent of which are iron and steel, primary aluminum, bulk cement, chemicals, paper, and glass – are what we are talking about when we discuss the potential for an energy-driven manufacturing boom. The size of these sectors would need to grow enormously to have revolutionary consequences for the fate of the U.S. manufacturing sector. Avoiding substantial decline, though, could be more feasible. Manufacturing growth tied to cheap natural gas is mostly a chemicals story. Take a look at the sweep of major energy-intensive industries, and you’ll find that most are still quite insensitive to energy prices. IHS-CERA, which is not shy about extolling the benefits of the “shale gale” (a term it coined), surveyed these areas in an ANGA-funded study on shale jobs late last year and came to some striking conclusions. Aluminum: “Lower U.S. natural gas prices could potentially slow or even halt the slow decay in the aluminum industry. However, it is unlikely that they would change the economics of primary aluminum production enough, even in the long-term, to redirect investment here.” Steel: “Cheaper electricity [due to low gas prices] will have only a small positive effect on this industry in terms of profitability and competitiveness.” Cement: “The electricity fraction of costs for cement production is too small to generate a significant impact on competitiveness, and the cost savings are not expected to cause production expansion and capacity investment.” There were, however, two industries that stood out. The (much) smaller one was “iron ore processed from taconite in the Great Lakes region”. Indeed several new projects, each of which would ultimately employ a couple hundred people, appear to be underway. The greatest potential, however, appears to lie in petrochemicals. The basic story is simple: natural gas is partly ethane and propane, feedstocks that makes up the bulk of ethylene and propylene producers’ costs. Greater natural gas production boosts ethane and propane supplies. So do lower natural gas prices, which can make it more profitable to strip out these liquids (not a cheap endeavor) rather than keep it in the gas to boost sales. (Ethane and propane increase the Btu content of natural gas, and thus the amount one can make by selling it.) On the flip side, the main competition for ethane and propane as  feedstocks is naphtha, a product of petroleum refining. High oil prices make ethane in particular a much better bet than naptha so long as oil and gas prices continue to diverge. (High oil prices tend to pull propane prices up, making propane unattractive as an ethylene feedstock.) This explains why we are hearing so much talk of resurgent investment in petrochemicals. A sense of scale, though, is essential. U.S. ethylene production capacity was about 29 million tons annually as of 2009. At a price of $1,300 a ton, that was worth about 40 billion dollars. Even if the United States were to double its ethylene production – an outcome, I hasten to mention, that no one is even remotely talking about – the revenues (not profits) would be another 40 billion.* That’s far from trivial, but it isn’t earth-shattering either. If you want to find manufacturing jobs related to energy, look at the supply chain. All the talk of oil and gas fueled manufacturing has muddled something essential: it’s production, not consumption, that’s mostly driving gains so far. This, not cheaper energy, is the main reason that you’re seeing steel plants stay open or expand – they are supplying drillers. Indeed proximity is particularly important in an emerging industry where interaction between customers (in this case drillers) and manufacturers is important to innovation. Some further numbers from IHS-CERA drive this home. The consultancy claims, quite plausibly, that as of 2010, shale gas production was supporting 39,000 direct manufacturing jobs and another 32,000 along the supply chain. It has projected (again not unreasonably) that these numbers could rise to 67,000 and 57,000, respectively, by 2020. This is far greater than the number of people that all the chemicals plants currently being discussed will employ. Oil and gas isn’t the only manufacturing-intensive energy business. If you think there’s a lot of steel in a gas well, wait until you take a look at a wind turbine. According to the American Wind Energy Association (to be certain, hardly a disinterested source), the U.S. wind industry employs 30,000 people in the manufacturing sector. The Solar Foundation (again, not disinterested) claims another 24,000 in the solar sector (including the supply chain). This is all on the back of an industry that remains much smaller than oil and gas. Let me make sure I don’t confuse people: no one should decide between fossil fuels and renewable energy based on the number of manufacturing jobs they each entail. That said, for policymakers thinking about how different developments might affect manufacturing, the numbers are instructive. There’s an important link between today’s discussions and climate policy. Remember when policymakers and advocates hotly debated the possible impact of carbon pricing on U.S. manufacturing? In those distant days (two years ago to be precise), claims that cap-and-trade would destroy U.S. manufacturing by raising energy prices were all the rage. Study after study challenged those claims, and legislation was crafted with provisions to safeguard trade exposed, energy intensive firms. Yet concerns remained. The present discussion about cheap gas and U.S. competitiveness is the precise mirror of that debate. The same sentiment that foresees a massive manufacturing surge on the back of low fuel prices is one that leads to alarm about the risks of carbon pricing. The same arguments that oppose creating new sources of gas demand (whether by promoting CNG cars or allowing LNG exports) based on worries about manufacturing competitiveness will come back to be used against carbon policy down the road. That’s worth keeping in mind as we think this issue through.     * The American Chemistry Council has claimed that a big increase in ethylene production should spark a similar rise in industries that use ethylene as a feedstock. There should be some movement along those lines, but I’m skeptical of the bigger claim: not long ago, lots of U.S. companies expected to import ethylene, which suggests that many ethylene users would have existed anyhow.

The boom in U.S. oil and gas production has spawned another gusher of increasingly hyperbolic claims about its revolutionary consequences. These are not just musings from the fringe; they’re increasingly becoming conventional wisdom, and not just among people who usually pay attention to oil and gas. An essay by David Ignatius in Saturday’s Washington Post, which relies heavily on analysis from Robin West, distills and enthusiastically endorses the emerging CW. I have a lot of respect for both men, but many of the claims that they and others are advancing have become detached from basic economic and geopolitical reality. I want to go through the Ignatius piece carefully and explain why. The central claim that Ignatius makes is simple: “Dependence on foreign energy, with the threat of supply disruption”, has been one of “America’s greatest economic vulnerabilities in recent time”, but is “on the way to being reversed”. The figures he presents to support these claims are ambitious but largely defensible. “Because of the rapid expansion of oil and gas production from shale,” he notes, “America is likely to become by 2020 the world’s No. 1 producer of oil, gas and biofuels.” West, he reports, “explains that the natural-gas boom will mean a dramatic change in energy imports and, thus, the security of U.S. energy supplies. He forecasts that combined imports of oil and natural gas will fall from about 52 percent of total demand in 2010 to 22 percent by 2020.” This strikes me as a bit garbled – it is tough to see how the gas boom gets you there by 2020 when the United States barely imports any gas in the first place – but the broader point, i.e. that oil and gas imports could fall from 52 to 22 percent of consumption by the end of the decade on the back of higher oil output and lower consumption, is not unreasonable. But this is no justification for the claims that follow: ‘This is the energy equivalent of the Berlin Wall coming down,’ contends West. ‘Just as the trauma of the Cold War ended in Berlin, so the trauma of the 1973 oil embargo is ending now.’ The geopolitical implications of this change are striking: ‘We will no longer rely on the Middle East, or compete with such nations as China or India for resources.’ This sort of assertion has become increasingly commonplace among smart people. A few weeks ago, the CEO of Pioneer Natural Resources told the New York Times that “To not be concerned with where our oil is going to come from is probably the biggest home run for the country in a hundred years.” Other examples abound. Yet I cannot for the life of me figure out the foundation of these claims. How does a shift from 52 to 22 percent import dependence translate into a fundamental reversal in vulnerability? After all, in 1973 itself, only 15 percent of U.S. oil and gas consumption (and only 26 percent of oil) came from imports. If 1973 ushered in a new age of energy insecurity, it is tough to see how a fall in imports to a level still higher than the 1973 one would reverse that. Moreover, there is no reason to conclude that “we will no longer rely on the Middle East” in any meaningful way. Here’s a thought experiment: imagine that the current confrontation with Iran were taking place in a world where only 22 percent of U.S. oil and gas was imported. Would we no longer be worry about potential oil market disruptions stemming from imposition of sanctions or military conflict? Of course not: we’d be worried about spiking prices and the consequences they might have for the U.S. economy. Lower import dependence would reduce that risk at the margin, but there is zero chance that it would come close to removing it. The same goes for the claim that we will no longer “compete with such nations as China or India for resources.” How else will we procure the remaining 22 percent (or whatever) of our oil and gas needs? Don’t get me wrong: I’m not suggesting that we’re going to go to war over hydrocarbon deposits. But we’ll be bidding against others (i.e. “competing”) for the marginal barrel of oil, just as we do today. Some might counter that the problem here isn’t that Ignatius and West have gone too far – it’s that they haven’t gone far enough. What would happen if the United States were to produce all the oil and gas it consumed? Set aside whether this is realistic; it still wouldn’t do the trick. Unless we were prepared to abandon the WTO and NAFTA, shutting the United States oil and gas sectors off from the rest of the world with all the consequences that would entail, we’d still be exposed (though less so than before) to price shocks stemming from Middle East and elsewhere, and would still be competing with China and others to buy resources on the world market, even if those were produced from underneath our own soil. But there is more. Ignatius’s column isn’t just about energy; it’s also about the resurgence of U.S. manufacturing. Here’s how he links the two: “Energy security would be one building block of a new prosperity. The other would be the revival of U.S. manufacturing and other industries. This would be driven in part by the low cost of electricity in the United States, which West forecasts will be relatively flat through the rest of this decade, and one-half to one-third that of economic competitors such as Spain, France or Germany.” Once again, these sorts of claims have become increasingly common. Indeed the quantitative assertions are perfectly plausible. But the big picture implications don’t make sense. As of 2010, total sales of U.S. manufactured goods were about five trillion dollars. At the same time, the sector spent about 100 billion dollars on energy. That’s a mere two percent of total sales. You could slash energy costs to zero, and it would barely move the needle for most U.S. manufacturers. There are, of course, exceptions, like some iron, steel, cement, and paper makers. But even these industries care about much more than their electricity prices. Will lower energy costs move things at the margin? Of course they will, and that’s good news. But they are nowhere close to what’s needed for U.S. manufacturing to broadly thrive. So let’s take a step back, because these disagreements aren’t just academic. They matter for at least three big reasons. There is a real risk that policymakers, wrongly convinced that surging supply has solved all U.S. energy vulnerabilities, will neglect the demand side of the equation. But the basic reality hasn’t changed: more supply can help, but to fundamentally reduce U.S. vulnerability to the vagaries of world energy markets, we need to rein in our extraordinary (and economically self-damaging) demand. This is matched by a danger (which I’ve highlighted before) that U.S. policymakers will do odd things if they start to believe some of the more revolutionary claims that are being peddled. For example, the United States is reassessing its military posture around the world. Mistaken beliefs about how much Middle East stability will or won’t matter to future U.S. economic security could distort the outcomes of that sort of process in problematic ways. I also worry that some policymakers, with the holy grail of energy independence seemingly in sight, will allow their cost-benefit judgments to get way out of whack. People who otherwise would have worried about protecting communities and the environment can become oddly eager to dig up a few mountains or drill through a dozen national parks when someone tells them that another million barrels a day of oil production will fundamentally change the U.S. position in the world. A more realistic view that sees marginal (though potentially large) rather than revolutionary benefits should produce more measured, and sensible, decisions. Don’t get me wrong: the oil and gas boom is a big deal. It’s spared the United States the need to become dependent on LNG imports, spurred the creation of hundreds of thousands of jobs, helped shield the United States from some of the consequences of high oil prices, and started to drive coal out of the U.S. electricity sector. That should be good enough news without needing to indulge in implausible hyperbole.

Perhaps my visit to Vienna last week has left me with too much Freud on the mind. But, as I talk to more people about the consequences of the U.S. oil and gas boom, I can’t help but conclude that we don’t need economists or geologists to help us figure what’s going on – we need a team of psychoanalysts. A few weeks ago I speculated that perceptions would play a big role in determining the impacts of the U.S. oil and gas boom. If U.S. policymakers came to believe that lower imports should make the United States more independent, they’d act as if that was true. Even if economic logic said that energy independence was a myth, the fact that policymakers believed otherwise would have real consequences. A series of recent conversations with overseas acquaintances has only reinforced my belief that it’s essential to understand what’s going on inside peoples’ heads if you want to anticipate the consequences on what’s happening on the ground. Take a recent chat with a well-connected Chinese individual. He told me that Beijing is concerned that the United States will start to neglect Middle East security and sea-lane protection if energy self-sufficiency becomes reality. That, of course, would cause problems for China, since it currently enjoys the benefits of those U.S. efforts for free. To the extent that Chinese leaders start taking steps to compensate for expected U.S. disengagement, those will have real consequences on the ground.  The big thing to remember here is that much of this could happen regardless of what U.S. policymakers actually decide to do. Or, if you want another example, take a conversation I had not long ago with a well-placed individual with stellar oil markets credentials from a Middle Eastern country that I won’t name. He was convinced that the United States wanted high oil prices. Why? High prices, he noted, would spur U.S. supply and hence make the United States self-sufficient. China, however, would suffer high prices without any similar response. That, he explained, would let the United States prevail over China for several decades to come. I assume that any U.S. official reading this will have started to laugh by now. But that’s quite beside the point: so long as others believe that this is what’s going on, they’ll act on that, with independent real world consequences. I don’t doubt that there are many more examples of how perceptions of what’s going on in the United States vary drastically from place to place and person to person. So a request to the far-flung readers of this blog: send me a short dispatch explaining how experts and policymakers in your country are interpreting the American oil and gas boom. You can do it in the comments or by email (and, in either case, I’m happy to make it anonymous). I’ll pull together some highlights for a future post.

The House Committee on Science, Space, and Technology held a hearing last week titled “Tapping America’s Unconventional Oil Resources for Job Creation and Affordable Domestic Energy: Technology & Policy Pathways”. I had assumed that the hearing would highlight attacks on Obama administration policies toward shale gas, shale oil, and Keystone XL, all of which have been prominent in the news. So I was struck to read the testimony of Karen Harbert, a former Bush administration official, Presdient & CEO of the U.S. Chamber of Commerce’s Institute for 21st Century Energy, and a prominent critic of the Obama administration. Most of her testimony is about something entirely different: the prospect of developing oil shale in the United States: “We have hundreds of years of oil supply stored in unconventional formations in the United States. In fact, the three states of Colorado, Wyoming and Utah alone contain more oil from oil shale than all of the conventional oil contained in the Middle East. This resource is so vast that when made commercial, it has the real potential to completely alter the global oil markets and secure America’s energy future at the same time. Yet it is the current policy of our government to ignore the value of these resources, sacrificing the revenue, jobs and huge security dividends Americans would realize from developing them.” First a quick explainer: “oil shale” and “shale oil” are two totally different things. “Shale oil” is what’s being produced in Texas and North Dakota using the same fracking techniques used to produce shale gas. “Oil shale” is basically rock that contains kerogen. You melt it (loosely speaking) to produce oil. It was a hot prospect in the late 1970s, but when the price of oil crashed, so did development. It is also hugely controversial: the local environmental impacts of shale oil development are often compared to those from Canadian oil sands extraction. Indeed the two basic techniques for producing oil shale – surface mining followed by processing, or in situ conversion, parallel those used to produce synthetic crude oil. Shale oil development also puts big demands on water resources, which (at best) would need to be carefully managed. And, of course, development of U.S. oil shale would increase greenhouse gas emissions, insofar as it didn’t displace other similarly energy-intensive oil. The biggest barrier to oil shale development, though, has long been the cost of extraction and the large amounts of up-front capital required. No one can honestly say that they know whether oil shale will make economic sense down the road. To be fair, though, denying industry an initial foothold will make finding out impossible. That’s the frame that Harbert sets up before criticizing the administration for putting oil shale resources off limits: “BLM (Bureau of Land Management) reduced the acreages for oil shale activities in Colorado, Utah and Wyoming by over three quarters, from 2 million to 461,965 acres.” That isn’t as consequential, though, as it sounds. We’re nowhere close to commercial-scale oil shale production yet. And research, development, and demonstration activities don’t require huge amounts of acreage. As several RAND Corporation authors explained a few years ago (in what remains the best analysis I’ve seen of oil shale), with “the ownership limit on federal oil shale leases… raised to 50,000 acres per state, private-sector investors in oil shale development have a much greater opportunity to profit from technically successful efforts.” Making nearly half a million acres available, then, would mean that at least ten or so companies could have a go. That should be plenty of opportunity to try new approaches and get a better sense of how much developing oil shale would really cost. It would also help us get a better handle on associated greenhouse gas emissions – which should inform any policy on large-scale oil shale development. And it would allow a gentle enough development pathway to avoid many of the environmental screw-ups we’ve seen in the Alberta oil sands – something that those who like and hate oil shale alike should support. Technical issues aside, though, I wouldn’t be surprised to hear more discussion of Obama administration restrictions on oil shale development as the year progresses. In an election season marked by a surprising focus on energy issues, candidates are looking for ways to differentiate themselves. For Republicans in particular, it seems that attitudes toward oil shale may fit the bill.

Prominent climate scientist Ken Caldeira has published an impassioned plea to those who care about climate change in which he essentially says that building (and presumably continuing to operate) any fossil fuel fired power plants is “immoral”. He is particularly upset by support for natural gas as an alternative to coal: if we emit greenhouse gases half as rapidly as we do today”, he points out, “we will wind up in the same place but it will take us twice as long to get there”. Cutting emissions without ditching fossil fuels entirely thus appears to be essentially worthless in his eyes. This is an increasingly popular line of thought, and it is badly misguided. Caldeira has done us the favor of laying out the case far more clearly than others have. I want to pick through it and explain why it’s wrong. Here’s the heart of Caldeira’s logic: “Economists estimate that it might cost something like 2% of our GDP to convert our energy system into one that does not use the atmosphere as a waste dump. When we burn fossil fuels and release the CO2 into the atmosphere, we are saying ‘I am willing to impose tremendous climate risk on future generations living throughout the world, so that I personally can be 2% richer today.’ I believe this to be fundamentally immoral.” This makes the decision look easy and lets Calderia get away with all sorts of simplistic arguments later on. But let’s be clear: No economist has argued that it would cost anything like 2 percent of “our” GDP (actually world GDP) to stop burning fossil fuels. Their estimates are for the cost of executing a measured transition from our present system to one involving far lower emissions, and the 2 percent figure is on the low end even for that. The cost of executing the transition that Calderia calls for – one that involves an immediate halt to fossil fuel plant construction – would be substantially higher. (And that ignores problems of harnessing an international response and the like.) It’s fine if Calderia and others think that that higher price is worth paying, but it would be far more persuasive if they said so forthrightly, rather than claiming that those costs don’t exist. That might also introduce some sort of limiting principle that would stop their logic from applying to pretty much everything we do. Want to eat some bread for dinner? That increases global food prices on the margin, and thus “impos[es] costs on strangers”. I know: it’s a silly analogy. But there’s no logical maneuver that ethically distinguishes this sort of impact from marginal climate damages. If you think that every CO2 molecule we willfully emit is a moral outrage, there are a lot of other things that you ought to oppose. What’s special about greenhouse gas emissions isn’t the fact that they hurt others at the margin. It’s that this damage often outweighs any benefit that flows from the activities that produce them – and that, when piled up, they can create massive risks. But this doesn’t lead to an absolutist and moralistic hostility toward anything that emits carbon – it leads to sensible weighing of costs and benefits that should drive us to steadily curb our emissions over time. (When I talk about costs and benefits, I mean it not only in the economic sense but in the political one too.) Some activities aren’t worth continuing once we fold in the climate damages they create. Others don’t make sense because their cumulative impact would be too dangerous. Heck, some might even be immoral. But, within this envelope, there are many activities that involve burning fossil fuels that are perfectly sensible and indeed productive, both in an economic sense and in the context of trying to develop a politically successful and sustainable climate strategy. Calderia argues that such political calculation is “compromised and logically indefensible”. That’s wrong unless you think that caring about climate change means that you must object to all greenhouse gas emissions – in essence, if you think that the damages caused by greenhouse gas emissions are infinite. It’s wrong unless you assume, like Caldeira, that substituting gas for coal (or for that matter deploying more efficient coal-fired power plants) is the last decision that humanity will ever make. But, as far as I can tell, it isn’t. A partial transition from coal to gas need not be forever, just like our current coal-dominated energy system needn’t be forever either. If Caldeira and others want to argue that substituting gas for coal will make it more difficult to ultimately move to zero carbon energy, perhaps on political or economic grounds, then that argument might have real force. So might an explanation for why opposition to all fossil fuels could lead politically to serious emissions-cutting action that’s commensurate with the scale of the climate problem. Even such arguments, though, would merely lead us back to assessments of costs and benefits, and to sorting through strategic calculations. Accusing opponents of one’s preferred emissions cutting program of being morally inferior is a poor substitute for confronting the real task at hand. Indeed, given how fractured the climate policy debate already is, it’s precisely the opposite of what the world needs.

I was worried that my defense of speculation in the oil market, published this week on ForeignAffairs.com, was late to the game, but my timing turned out to be right on. Just yesterday, an op-ed appeared in the New York Times by Joseph P. Kennedy arguing that “pure” speculators should be “banned from the world’s commodity exchanges.” I am wholly sympathetic to Mr. Kennedy’s motivation—to make sure that the wealthy do not profit at the expense of those of more modest means, who are genuinely hurt by high and volatile prices for staples like heating oil, rice, and other goods. But the recipe for a better-functioning oil market that he cooks up is not the answer. I’d like to address a few of the major points that Mr. Kennedy makes in his piece. Let’s start with his conclusion: "Federal legislation should bar pure oil speculators entirely from commodity exchanges in the United States. And the United States should use its clout to get European and Asian markets to follow its lead, chasing oil speculators from the world’s commodity markets." Commodities markets need at least some what he calls “pure” speculators (meaning those who act as brokers or investors rather than actual producers or consumers of oil) in order to function. This isn’t just my opinion. Commissioner Bart Chilton of the CFTC—hardly a shill for Wall Street—hammered home in a speech last month that “Speculators are necessary liquidity providers to [commodities] markets.” In other words, “pure” speculation is an essential part of the oil market. Why is that the case? As I tried to explain in my ForeignAffairs.com piece, oil producers and consumers use financial markets to hedge their risk. But they need someone willing to assume that risk. In industry jargon, they need a counterparty to trade with. At times, oil producers and consumers are able to trade among themselves, but not always. That’s where “pure” speculators come in. For example, Chevron might contract in advance with Southwest Airlines to sell it 1,000 barrels of jet fuel for delivery in New York in 2015. But what if Southwest needs to buy a certain quantity or type of oil for future delivery and no oil producer can commit to providing it for them? That’s when a speculator, acting as a broker, can be useful. He takes the other side of the trade with Southwest for the time being. Then, when an actual oil producer decides it can deliver Southwest what it needs, the speculator sells the contract to the producer. The deal is done. If companies choose to contract with one another directly, rather than through a speculator acting as an intermediary, they are free to do so. But were such intermediaries banned from the market, as Mr. Kennedy calls for, companies that would like to minimize their risk by pre-buying or pre-selling oil would often be stymied. The amount of damage an oil producer or consumer could suffer by losing out on the ability to hedge is huge. Back to the example of Southwest Airlines—as oil prices trended upward between 1998 and 2008, the company saved more than $3.5 billion thanks to hedging in the oil market, while many of its peers that didn’t hedge suffered. Pure speculators enabled it to rack up that magnitude of savings. The op-ed also makes the following claim: "Because of speculation, today’s oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide." This paragraph reflects a misunderstanding about how oil prices are determined in the marketplace. The market price of oil has to do with marginal production costs, not average costs. That means that the most expensive barrel produced to meet global demand is also the one that more or less establishes a floor for prices. Right now, many experts reckon the marginal cost of production is the cost of producing oil shale and oil sands. Barclays Capital reckons that extracting oil from Canadian oil sands requires an oil price of at least $85 to be economically viable. Once you correct for that error, you realize that $100 oil is not far-fetched, especially in light of ongoing geopolitical disruptions. It continues: "Pure speculators account for as much as 40 percent of that high price, according to testimony that Rex Tillerson, the chief executive of ExxonMobil, gave to Congress last year." This claim—that Wall Street speculators account for as much as 40 percent of oil prices—is Mr. Tillerson’s estimate, but I have not seen any publicly available study to support that figure. (If I’m mistaken, I’d love to see the report--please send it to me.) Discerning analysts should bear in mind the circumstances under which Mr. Tillerson provided that estimate. Under pressure from Congress last year, oil company executives were called to Capitol Hill to explain why oil prices were so high. They were right to defend themselves. Oil companies receive far more blame in the popular media when gas prices are high than likely they deserve. Still, I have not seen any data validating the 40 percent figure he cites. Mr. Kennedy argues that the 40 percent estimate “is bolstered by a report from the Federal Reserve Bank of St. Louis.” That’s far from the case. The report he’s referring to is being cited frequently as evidence that speculators are running wild in the oil market, causing prices to move in whatever direction they’d like. But that’s not the study’s primary finding at all. It concludes that “On balance, the evidence does not support the claim that a sudden explosion in commodity trading tectonically shifted historical precedent” (emphasis mine). The bottom line is that “the increase in oil prices over the last decade is due mainly to the strength of global demand” and that “fundamentals continue to account for the long-run trend in oil prices.” The study suffers from some severe methodological limitations due to a lack of data, which calls into serious question its conclusions about how pure speculators affect prices (it says they were up to 15 percent of the 2004 to 2008 price run-up), but there it is. More on that study in another post. Oil prices can certainly diverge somewhat from supply-and-demand fundamentals for periods of time. That problem is exacerbated by the opaque and contradictory data about what’s happening in the global oil market, which gets in the way of the market’s efforts to determine fair value for the good. My colleague Daniel Ahn has written an excellent CFR piece describing this phenomenon and its implications for regulation. Oil speculators can and do fall prey to irrational exuberance from time to time. Ultimately, though, you’d still be far more accurate to blame supply and demand than you would Wall Street for pain at the pump right now. I applaud Mr. Kennedy’s desire for sound, proactive regulation of commodities markets. Traders operating within them should continue to be subject to reasonable rules and restraints to prevent abuse, fraud, and manipulation. Where speculators are guilty of illegal practices, they should answer to the law. The CFTC is wise to weigh policy options to improve these important markets. Unfortunately, Mr. Kennedy’s prescription for fixing them is not the right one.

You’re not going to win any popularity contests being a speculator in the oil market these days. As if Occupy Wall Street weren’t bad enough, a significant percentage of the American public is convinced that speculation is the reason why it’s costing them so much to fill up the tank. Comments by President Obama, Attorney General Holder, and Congressional leaders suggesting that speculators may be to blame for pushing oil prices higher over the last few months have added heft to these claims. But is speculation in the oil market all bad? What is speculation, anyhow, and is it responsible for the nation’s energy woes? They’re hard questions that have been the subject of tremendous debate--and misunderstanding--in the popular press. I weigh in on the controversy at ForeignAffairs.com. Check it out here.

U.S. coal production is down but exports are up. That’s led to widespread warnings that efforts to curb U.S. coal consumption won’t do much if anything to slow climate change unless the United States bans exports too. That conclusion strikes me as premature. Brad Plumer, writing yesterday at the Washington Post, presents the argument for worrying about exports clearly: “In 2011, the United States exported even more coal to countries like Brazil, South Korea and Europe, just as its own consumption was falling. That’s evidence in favor of the idea that if the United States won’t burn its vast coal reserves, then other countries will be happy to take the coal off our hands. And if that’s true, it would mean that the government’s recent spate of power-plant regulations aren’t helping the country make much progress on climate change. After all, carbon-dioxide that’s released by burning coal will heat up the planet no matter where it’s burned.” But that’s only half of the equation. Increased U.S. coal exports will raise global greenhouse gas emissions if and only if they supplement other coal production rather than displace it. On that count, we’re actually flying pretty blind. There’s reason, though, to suspect that a good part of increased U.S. coal exports would come at the expense of others’ output, which means that it wouldn’t increase net global greenhouse gas emissions. Last year, the IEA tried to model how country-by-country coal output would be affected if the world slashed its coal consumption. It found that Chinese, Australian, and Indonesian production would be cut deeply, but that U.S. production would hold up far more strongly. This suggests, at a minimum, that substantial U.S. coal exports are compatible with a lower-carbon world. Of course, one model isn’t anywhere close to dispositive. Nor does the IEA sketch imply that constraining U.S. coal exports wouldn’t reduce global coal consumption further. But it does suggest that the possibility of U.S. coal exports doesn’t necessarily mean that cutting U.S. coal consumption would be for naught. This is a place where people with decent coal trade models – there are a few out there – could really help illuminate a critical policy choice.

In a post last Thursday, I identified four reasons for skepticism about a new IHS report that estimated the impact on energy markets of the currently proposed implementation of the Volcker rule. Kurt Barrow, Vice President of IHS Purvin & Gertz and lead author of the IHS report, has graciously penned the following guest post addressing the questions I raised. I may comment further on a few of the points below in another post. We appreciate your careful and thoughtful reading of the report. On behalf of the IHS team that completed The Volcker Rule study, I would like provide the following response to the questions and concerns you raised. You ask why non-bank institutions, such as hedge funds, would not provide some long-term risk management services.  The Congressional intent of the Volcker Rule was specifically to allow the bank to continue to provide market making and hedging services to their clients, The Volcker Rule sees this as a constructive role.  It is, in our view, the regulations as drafted that could to prevent the intent of the Volcker Rule from being realized.  It is the same point that Mark Carney, governor of the Bank of Canada and chairman of the Financial Stability Board, made when he said that the regulations – not the Rule – would “if adopted as drafted” could “limit market-making and risk management activities.”  Speaking of the impact of the regulation as drafted, he added, “the rule, as currently drafted, could reduce global financial resilience rather than increase it.” Regarding non-bank institutions, such as hedge funds, providing risk management and intermediation, it certainly was not obvious to us who the natural players, with the requisite capabilities, could be to adequately fill any “void,” at least for some period (our modeling was based on five-years).  This role requires an “A” credit rating or better, in order to be a viable counterparty that most corporations could even consider doing business with, and especially for long-dated contracts.  It also requires a client-facing business model with account executives out calling on American companies to identify their needs and develop client solutions.  It requires a willingness to provide financing, which is often an important component of many structured solutions.  And on occasion, this activity demands someone capable of straddling both the physical and financial markets, in order to efficiently provide an effective client solution.  Hedge funds are certainly not a good fit with the requisite positional assets and organizational capabilities of this role. Regarding the concept of moving substantial portions of the OTC trade to futures exchanges, there are a two constraints that make this particularly difficult for energy companies.  First, as you point out, exchanges provide only a standardized set of derivatives while OTC contracts are tailored to the commodity size, quality and location for each client.  An airline may not find it useful to hedge jet fuel with a WTI contract.  One important result, is that this usually allows firms to achieve hedge accounting, which is an important element of realizing the earnings stabilization that they seek.  Second, exchanges have no bilateral mechanism on which to base a physical-to-financial hedge offset in the margin requirement.  As a result, if the exchange derivative moves “against” the position, margin calls occur for the full duration of the hedge, even if the value of the physical stream offsets this financial “loss.” By contrast, in OTC markets, a counter-party that understand’s a firm’s business and commodity purchase/sales needs can structure contract terms so that margin requirements account for the actual physical commodity flows. For the economic impact, the IHS Global Insight macroeconomic forecasting model was used.  The fuller description is provided in the report.  The natural gas production-related jobs impact is largely driven from the investment reduction of $7.5b per year, not from the gas sales revenue.  This study reports on the combined total economic impacts, which includes the direct, indirect, and induced impacts across all sectors of the economy and not just energy sector jobs.  We believe the employment-to-investment results are reasonable and consistent.  This is a standard way to calculate jobs impact. To the question of benefits from this Rule, we agree these exist.  In fact, as we have said, the report is not in disagreement with the intent of the Volcker Rule and the prohibition of banks from proprietary trading.  We do, however, struggle to see the benefit gained from reducing the ability of energy producer and consumers – ranging from airlines to independent natural gas companies—to manage price risk, an outcome that is foreseeable with the current proposed implementation. Finally, we are not arguing for a course of action either way. As researchers, our task here was to examine the potential impacts of the rule as it is envisioned in the current regulatory drafts.  The report was conducted in response to a specific call from the regulators, who, recognizing the importance of getting the regulations right, asked for comment.  And our findings tell us that the current regulations would have potentially major impacts on the energy industry, other industries, and energy prices with resulting impacts on jobs.  The current regulation would not achieve the intent of the Volcker Rule.  While our report did not provide specific policy suggestions, it seems that the findings of our report are consistent with recent calls, by Representative Barney Frank and others, that a simpler, more principles-based regulation might be provide the path forward.

A new study out yesterday claims that the Volcker rule, intended to push proprietary trading out of the banks, could end up slamming the U.S. energy sector, slashing two billion cubic feet a day off natural gas production and costing two hundred thousand jobs. The alarming report, commissioned by Morgan Stanley and written by the consultancy IHS, is making waves. I am, to put it mildly, not convinced. The essence of the IHS argument goes something like this. Much of the U.S. energy industry depends on selling its production forward in order to stabilize cash flow and make long term investment possible. This is particularly true for firms that produce unconventional gas. And while markets for exchange traded near-term gas futures are incredibly liquid, the same is not true for the longer-dated contracts that are essential to much of the business. Instead, producers tend to hedge their long term exposure (6-month to 5-year horizons) through bespoke over-the-counter (OTC) contracts with banks. For a variety of interesting technical reasons that are described in the report, the Volcker rule might make it impossible for the banks to keep providing that service, at least at the same scale as they do today. So far so good, but what comes next is more questionable. The IHS authors show that increased hedging has been correlated with increased investment. They then use that relationship to predict the impact on investment if long term hedging services were to disappear. By far the biggest impact is in natural gas production, though the authors project small impacts in several other places too. I’m skeptical on four main grounds. The authors never attempt to explain why non-bank institutions, such as hedge funds, won’t step in to provide at least some long term risk management services. (There is a brief observation that large integrated oil and gas companies might do that, but it’s never accounted for in the ultimate analysis, which appears to assume that hedging services will vanish.) Perhaps there’s a good argument for why others won’t be up to the task: maybe the scale of capital required is too large, or the overhead burden associated with providing the service requires economies of scale that hedge funds and other non-bank institutions can’t muster. But that argument needs to be made if the broader point is to be sustained. (It isn’t enough to note, as the study does, that the cost of hedging might rise, since the ultimate analysis implicitly assumes that the cost will be infinite.)  As it stands, all the study really argues is that big banks will be out of the game. It is also unclear to me why exchanges might not pick up much, or at least some, of the slack. I understand why producers like OTC contracts: they’re more tailored to their needs than standardized derivatives are. But I don’t see why, if the availability of OTC hedging services were severely curtailed, a much larger market for long-dated futures couldn’t arise on exchanges – or at least I don’t see why such an outcome isn’t possible. The substitute wouldn’t be perfect – there would be more risk to producers since the derivatives wouldn’t be tailored to their specific needs – but I could imagine it becoming a pretty decent replacement if today’s preferred option were curtailed. My third problem is with the analysis of economic impacts. Let’s accept for the moment the IHS estimate that the currently proposed implementation of the Volcker rule would slash about two billion cubic feet a day off U.S. natural gas production by 2016. Would that really kill 200,000 jobs? I have a difficult time believing that. Let’s say that natural gas is going to be selling for five dollars per thousand cubic feet by 2016 (roughly the current futures price). That adds up to revenues of about four billion dollars a year. It is hard to see how this will support 200,000 jobs, which would imply about $20,000 in revenues (not profits) per job, unless we use some pretty big multipliers and assume that all the people employed and capital used would have been on the sidelines otherwise. That is a stretch. But the biggest problem with the study may not be with how it weighs the costs of the Volcker rule – it may be the fact that it completely ignores any benefits. Imagine that someone had written the following claim in 2007: The U.S. government is proposing to bar banks from trading in mortgage backed securities. Yet banks play a central role in making markets in these instruments. Prohibiting them from risk taking in this area would curtail the ability of originators to offer low cost home loans to the American people. This would be tragic: mortgage brokers, by offering innovative products, have helped millions of people attain the American dream. In the process, they have helped grow the construction industry, creating hundred of thousands of new jobs. All of this would be at risk with the new rule. Sound ridiculous? It should. Much of that argument about the costs of bank regulation would have been correct – yet no one, with the benefit of hindsight, would now say “the financial crisis was a price worth paying for keeping mortgages cheap”. I am not suggesting that the natural gas industry today is like the subprime mortgage industry was five years ago – indeed I’ve argued against that point before. But the arguments coming from the banks today are remarkably similar, and the same sort of skepticism would be wise. Indeed there is one line in the IHS study that I find particularly troubling: “Banks play an important role as liquidity providers in less liquid markets, particularly niche and long dated markets. The strong credit quality of many banks makes them a preferred counterparty to transact with.” And why do the banks have such great credit quality? You’re staring at part of it every time you look in the mirror. The financial crisis proved that the U.S. taxpayer will be on the hook if a big bank ever again threatens to go down. That is the reason for the Volcker rule, and part of the reason for banks’ superior credit quality. If people really believe that government should subsidize risk taking by private energy producers through implicit support for the banking system, they should stand up and say it. Let me be clear: there are undoubtedly places where the proposed implementation of the Volcker rule can be improved so as to better distinguish market making activities from proprietary trading. That, despite its actual content, is how the IHS report is framed -- and, to be sure, drawing the distinction is a nightmare. Yet the report says nothing about what changes might be wise and what activities might safely be offloaded from the banks. (This is not the fault of IHS – it presumably was not part of its contract.) Focusing on those details would be a far more constructive avenue of debate.

Anticipation is heating up around another release of oil and petroleum products from the U.S. Strategic Petroleum Reserve (SPR), likely in coordination with the United Kingdom, France, and possibly others. But there are profound concerns with using strategic reserves to manage prices in the short-term. As John Deutch of MIT pithily put it, this is using our national oil stockpile as a tactical rather than strategic petroleum reserve. And history is littered with the graveyard of various government attempts at managing commodity prices, such as the buffer stock stabilization programs by South and Latin American countries in the 1960s and the Nixon Administration’s attempt at price controls in the 1970s. And with very good economic reason, something that I will discuss in more depth in subsequent posts. But politics in an election year rarely plays second fiddle to sound economics. If one still insists on using strategic stockpile releases for tactical price management, then at least try to make sure that the price increase one is fighting is temporary rather than permanent. A permanent price increase driven by fundamental supply and demand will shrug off any attempt at tactical price stabilization. But a temporary price increase due to a transient disruption such as a hurricane or seasonal demand (or stretching it, geopolitical event with a finite horizon) may be mitigated with a stock draw-down. A helpful guide is to watch what the private sector is doing. If the market thinks recent price jumps are temporary, they will draw down inventories to tide over current demand and rebuild them in the future when prices are expected to be lower. On the other hand, if the market thinks recent price jumps are permanent, then the private sector will keep inventories level or even build them in anticipation of further price increases. (Actually, even if prices don’t change but price volatility increases, then inventories would be built due to the option value of having storage.) If a government tries to make a tactical release in the face of permanent price increases, then it is fighting the private sector. Any government releases may be counterbalanced or even directly absorbed into private sector builds. This arguably may have defeated the previous SPR release last year. A point in favor of an impending release is that at least private inventories in the places we can observe them (basically, the OECD) have declined considerably since last year, suggesting markets may be seeing recent price rises as temporary (see chart). On the other hand, this may also be because weaker economic growth and lower demand in developed economies may be disincentivizing the private sector from holding inventories. Furthermore, there are anecdotal reports that the private sector or even governments in less transparent areas of the world may be building stockpiles. It is pretty disappointing if any oil released out of the U.S. SPR is ultimately ending up (given fungible oil markets) in Chinese strategic reserves. It is hard to determine what the full picture is saying. This is another reason why fundamental data on demand, supply, and inventories is so critical for the proper functioning of energy markets. So bottom line, if you have to do tactical stockpile releases, only counter temporary price increases. Try to follow rather than fight the private sector inventory decisions. Make an extra effort to ensure that SPR release do not disappear into private storage, for example, with direct sales to end-user consumers and refiners rather than recipients with access to storage facilities. For the future, consider having some of the SPR in the form of refined products, which is a lot costlier to store and therefore more likely is actually used rather than stockpiled.