Dirty little secret

Jeff Frankel argues that the Democrats are right to oppose off-shore drilling, but for the wrong reasons:

The Democrats have it precisely backwards. The problem with Republican proposals to re-open domestic oil drilling is not that we desperately need the oil right now, whereas new oil discoveries would not come on line for 5 to 10 years. Rather it is that we might truly desperately need the oil in 20 or 30 years, and so don’t want to use it up over the next decade. …

We don’t want to maximize current domestic production. Rather we want to leave the oil underground (or underwater) for decades, until we really need it, until we are so desperate that the economic benefits really do outweigh the costs.

This is the same dynamic that Rich mentioned a couple weeks ago: our decision to leave a bunch of our domestic oil in the ground looks like a pretty good investment decision now that oil is an order of magnitude more expensive than it was a decade ago.

But I am not convinced by Frankel’s argument that oil will march ever upward at astronomic rates and in 30 years we will be happy we left it in the ground. I can imagine states of the world where the price of oil is $20 in 30 years. (Perhaps a result of a battery-powered transportation fleet combined with electricity from renewables, nuclear, and CCS plants.) At the very least economic theory tells us that when both supply and demand are very inelastic that small changes in either can result in very, very large price changes. No one in 1980 thought oil could ever drop to $10 a barrel again. It did.

The dirty little secret of energy policy in the U.S. today is that opening up our domestic reservoirs would almost certainly pass any reasonable cost-benefit test.

The way to perform a cost-benefit calculation is not to assume that you know the future distributions of costs and benefits (as Frankel does). The cost and benefits we measure today are the best estimates we have. We should use them and have an honest debate about whether we want to drill domestically.

This doesn’t mean we shouldn’t try to give our best estimates of the distribution of future costs and benefits. Historically, our preference for environmental quality has risen over time. We should consider that the next generation may place an even greater value on a pristine ANWR or ocean shelf than we do. We should also try to think realistically about what oil prices are going to be.

But recall also that a couple weeks back I pointed readers to a research paper [ungated version here] that found that opening ANWR would lead to benefits of $1141 per person in the U.S., and this was at an oil price of around $53 per barrel. In other words, the environmental costs (or our willingness to pay to prevent environmental damages) would have to be more than $1000 per person if drilling in ANWR were going to fail a cost-benefit test. At current oil prices it seems inevitable that domestic drilling would pass.

This does not imply we should necessarily drill. There are many metrics besides dollar values for making decisions about our environmental management and energy policy. But I have yet to see anyone in this debate honestly state the facts about domestic drilling. The lie Republicans will tell you is that domestic drilling will lower oil prices. The lie Democrats will tell you is that because it won’t it’s not worth doing.

$1141 divided by $53 times…

Just to put some numbers on the point Rich made about ANWR this morning, here’s the abstract of a paper [ungated version here] from one of my former professors:

This paper provides model-based estimates of the value of oil in Alaska’s Arctic National Wildlife Refuge (ANWR). The best estimate of economically recoverable oil in the federal portion of ANWR is 7.06 billion barrels of oil, a quantity roughly equal to US consumption in 2005. The oil is worth $374 billion ($2005), but would cost $123 billion to extract and bring to market. The difference, $251 billion, would generate social benefits through industry rents of $90 billion as well as state and federal tax revenues of $37 billion and $124 billion, respectively. A contribution of the paper is the decomposition of the benefits between industry rents and tax revenue for a range of price and quantity scenarios. But drilling and development in ANWR would also bring about environmental costs. These costs would consist largely of lost nonuse values for the protected status of ANWR’s natural environment. Rather than estimate these costs and conduct a benefit–cost analysis, we calculate the costs that would generate a breakeven result. We find that the average breakeven willingness to accept compensation to allow drilling in ANWR ranges from $582 to $1782 per person, with a mean estimate of $1141.

And from the section of the paper on the benefits of drilling:

As stated previously, two benefits of drilling in ANWR that are often put forth are a decrease in the price of oil and reduced reliance on foreign imports. The numbers above suggest, however, that neither of these benefits is likely to be consequential. Domestic oil prices are determined in a world market and would be unaffected by the relatively small annual flows from ANWR. Moreover, the quantity of oil in ANWR, 7.06 BBO, is merely 0.55% of the proven reserves worldwide (EIA, 2006b). Analysts also recognize that even if ANWR’s supplies were large enough to affect world prices, the Organization of Petroleum Exporting Countries (OPEC) would countermand the increase in production and thereby negate any price effects (EIA, 2004; Gelb, 2005). It is also clear, with ANWR accounting for a maximum of 3.2% of domestic consumption in 2025, that something other than drilling in the Refuge will be necessary to substantially reduce our dependence on foreign oil.

…

The benefits that would be real and substantial are the economic rents and tax revenues that would arise from drilling in ANWR. From a social perspective—the one used in benefit–cost analysis—it is important to recognize that the oil is not worth the total revenue that it generates. There are opportunity costs associated with finding, developing, producing, and transporting the oil, along with the required rate of return on capital. The only portion of total revenue that would generate a benefit to society is the net return, which would consist of economic rent to the oil industry and state and federal tax revenues.

We extend the USGS model (Attanasi, 2005b) to estimate the economic rents and tax revenues that would arise from ANWR oil. The first step of deriving an estimate of total revenue is straightforward. For any given price, we multiply the price times the quantity of oil indicated by the long-run marginal cost curve in Fig. 1. Using our best-estimate scenario of $53 per barrel and 7.06 BBO, total revenue is $374.2 billion. Considering the 95% and 5% certainty scenarios, the estimate of total revenue ranges from $203.0 billion to $565.3 billion. Table 1 reports the estimates of total revenue for the full range of prices evaluated under the three different scenarios. [emphasis added]

Their alternative scenarios vary the amount of recoverable oil but not the price. They don’t consider prices above $59 per barrel. I’ll outsource the commentary to John Whitehead:

It is hard to imagine nonuse values over $1000 for ANWR (even if these are for households and not individuals). The nonuse values that I played around with 2 years ago are all less than $50.

Addendum: The values are for individuals age 18 or over.

The hedge value of domestic oil conservation (or, “I’m rich, B*tch!”)

John McCain caught a lot of heat last week for proposing to open up offshore drilling. This is largely because he proposed doing so as a response to high gas prices. As people quickly pointed out, not only would it take 10 years before the first drop of oil came out of these offshore endeavors, but the entire operation would be so small relative to global production that it would have virtually no effect on the price of oil. In fact, as the WonkRoom noted, even McCain’s own advisers acknowledge that offshore drilling wouldn’t impact current prices. This prompted a predictably econo-idiotic restatement from the Maverick, where he tried to justify offshore drilling as impacting the psychological price of gas, not the actual price (maybe this is behavioral econ?).

However, talking to Daniel today about all of the the oil speculation nonsense today, we stumbled on a reasonable justification McCain could give to explain his offshore drilling flip flop: “I’m rich, Bitch!” As Wyatt Cenac brillantly explained on the Daily Show in response to Obama’s flip flop on accepting public financing, “we all say things we don’t mean just before we get rich….voters will forgive him once they take a ride in his brand new Hummer-copter.”

While, then as now, opening up off-shore drilling in the US won’t significantly reduce gas prices, what it will do is bring in a boatload of money to the US.* Back when oil was $20 a barrel, this revenue stream seemed far too small to sacrifice the serenity of of our oceans. But with analysts predicting $200 a barrel oil in the near future, it might be time for us to reconsider. When a democracy decides whether to conserve land or not, it values the costs and benefits of both options. I’m not saying we’re at a point now where we should drill, but it’s not entirely unreasonable to change one’s stance on an issue like this once the relative pros and cons have changed.

Which brings me to the point of this post. From a financial perspective, the decision to delay drilling in ANWR a decade ago is looking pretty prescient. Assuming that the resulting environmental damages and quantity of oil in the ground haven’t changed, it’d be much more beneficial to crack ANWR open now. As I see it, the public panic over recent run up in gas prices has less to do with the current level, and more to do with the fact that there’s no end in sight. If people believe that we won’t be able to wean ourselves off oil quick enough and that prices will continue to rise, then it should be somewhat comforting to know that if things really do get bad we can somewhat offset these negative effects by cashing in our untapped reserves. Otherwise, if people believe that the recent crunch is a brief abberation, that either oil prices will come down or we’ll simply learn to use a lot less of it, then it probably seems imprudent to permanently spoil the environment. Either way, a reasonable, informative public debate over the relative costs and benefits seems a lot more helpful than atemporal categorical rejections.

* In this example I’m assuming that the federal government would either auction off drilling sites, or extract royalties from companies who find oil offshore, and return a dividend of the proceeds to every American. In reality, most of the profits gained from offshore drilling would go to American oil companies. In the case of McCain’s plan, I think its pretty safe to assert that he’s thinking about placating Houston, not offsetting the increased transportation costs of American families.

Cross-price elasticity: conservation vs. oil

As I emerge from a long hiatus (Argentina and catching up with work upon my return), I’m going to ease back into blogging with a very brief econ 101 post.  Hopefully my economic intuition and vernacular aren’t too rusty (feel free to tear into this post* — it’s the only way I’ll get back in stride).  From the LA Times:

John McCain returned to Santa Barbara this week not to assert his opposition to offshore drilling — as he did when he ran for president in 2000 — but to make the calculated gamble that high gas prices have trumped voters’ desire to protect the environment…

We talk a lot about the environmental benefits of higher fuel prices as people change their lifestyles to reduce their consumption of fossil fuels.  However, it’s easy to forget that in some locales, the opportunity cost equation for environmental protection can include increased oil supply.  Essentially, conservation and fuel are an odd sort of complements.  When the price of fuel goes up, the demand for environmental protection curve shifts inward.  In the past, it seems that this cross-price interaction has been relatively inelastic, but this might be changing as we arrive at new reaches of the fossil fuel demand curve:

Los Angeles Times polls show that, in California, opposition to offshore drilling has not weakened even during past energy crises. But new national polls have shown that the country, burdened by exploding gas prices, supports drilling in sensitive areas.

Keep in mind that the impact on world oil prices from drilling in specific sensitive areas is likely to be small and somewhat temporally distant (see: ANWR), but this fact can easily be obscured by rhetoric and poor information.  Luckily, politicians usually try to stay away from those kinds of things…

*I’m guessing Daniel and I might not be friends anymore by this afternoon.

Links yo

1. Ajay Shah has a nice, thorough post on what’s going on with food prices, debunking several common explanations and putting forth a reasonable, if unsexy, story of his own.
2. Paul Kedrosky challenges the conventional wisdom that OPEC always prefers high oil prices. Persistent, predictably high oil prices would encourage people to switch to alternatives. Instead, he argues that what OPEC prefers is a series of high prices, unpredictably interspersed with periods of very low prices. Saudi Arabia’s role in curbing excessively high OPEC prices has been pretty well documented. It’d be interesting to see any evidence that the Saudi’s actually undercut price with the deliberate intention of warding off substitutes.
3. Finally last week’s Economist has a briefing on energy efficiency. Overall I found the piece a bit elementary and far too dependent on the McKinsey report. Nevertheless, it’s a good intro for readers who are new to the topic.

H/T to Thom for the first two links.

Tight

Yes, this McCain-Clinton idea to suspend the gas tax is stupid. I think the best quote I’ve seen so far comes from Len Burman via Greg Mankiw:

Yesterday I was on the NewsHour to talk about the gas tax holiday. I asked if there was another guest and the producer said, “We tried, but we couldn’t find anyone to argue the other side (that the gas tax holiday made sense).”

The more interesting part of the discussion is not the piling on — though certainly people should be pointing out how mind-bogglingly stupid this proposal is — but the discussion about tax incidence. Most commenters are arguing that producers will benefit more than consumers from the tax holiday, because summer oil supply is very tight. As Greg Mankiw describes it:

What you learn in Economics 101 is that if producers can’t produce much more, when you cut the tax on that good the tax is kept . . . by the suppliers and is not passed on to consumers.

Or here’s Paul Krugman:

Why doesn’t cutting the gas tax this summer make sense? It’s Econ 101 tax incidence theory: if the supply of a good is more or less unresponsive to the price, the price to consumers will always rise until the quantity demanded falls to match the quantity supplied. Cut taxes, and all that happens is that the pretax price rises by the same amount.

But Tim Haab is not so sure that supply is less responsive than demand. He nails the theoretical explanation. In fact, if you really want a great straightforward description of tax incidence, see this pair of posts he wrote just last month. Pay particular attention to the chart in the second post, which graphically depicts what he says here:

Only two cases are clear cut. If buyers are price insensitive and and sellers are price sensitive (top right panel), the buyer will bear the burden of the tax. If sellers are price insensitive and buyers are price sensitive (bottom left panel), sellers will bear the burden. In cases where both are sensitive or both insensitive, the results are unclear and depends on the relative sensitivities.

But in arguing today that producers are more price sensitive than many people may think he gets some facts badly wrong. Specifically he uses this chart to argue:

So when will supply of gas be perfectly inelastic? The most obvious answer to me would be when refineries are running at full capacity over the relevant range of prices. That is, regardless of the market price, refineries can’t keep up. Is that the case? The chart to the right gives U.S. refinery capacity and gasoline consumption in gallons per day from 2002-2007. On average, U.S. refineries produce at about 50% capacity. (emphasis added)

No. Just… no.

The problem is Tim compares refining capacity data to gasoline consumption. This is an apples-to-oranges comparison. Capacity is measured by the input — crude oil — and this is being compared to a specific output, gasoline. But refineries produce many things besides gasoline — jet fuel, home heating oil, etc. — and even if every U.S. refinery were optimized to make gasoline (which isn’t the case) there would still be losses from the refining process itself.

As it turns out the EIA* actually publishes weekly data on refinery capacity margins (or “percent operable utilization” as the EIA calls it). I downloaded the series to create the chart below. Note that with the exception of Katrina (September 2005) that refineries have run at 80-98% capacity over the last few years (most typically from 85-95%). Note that there is also a seasonal pattern: utilization usually declines in winter and peaks in summer. This would imply less elastic supply in summer. Note also, however, that refineries are entering this particularly summer with the lowest capacity utilization rates we seen in spring in awhile, around 85% instead of 90-95%.

What would I conclude from all this?

1. If you wanted to maximize the portion of this tax ‘refund’ that went to oil companies, you should make the gas tax holiday during summer, when supply is most inelastic.

2. Compared to previous years, producers would probably benefit less from the gas tax holiday this year, since capacity margins are down.

3. Despite the factual errors and the incorrect implication that summer gas supply is fairly elastic, Tim is probably right when he says, “maybe the tax holiday might have some effect on both consumers and producers.” Why is that? Remember, demand for gas is also very inelastic. In other words, which world are we in? I say the bottom right case in this chart.

This guy sums it up pretty well when he says,

the gains of the tax cut will be split evenly between producers and consumers… I’m not saying that the gas tax cut is a good idea. In fact, I think it’s horrible pandering that wont help anyone in the long-run.

*Public service announcement: when using energy data about the U.S. to back up any argument, please avail yourself of the EIA. If you can’t find what you need, look again. Still not sure? Check a third time. The EIA is amazing. Use it.

It’s summertime, and the gas is expensive

I’m becoming more and more interested in the actual processes involved in crude oil refining and fuel blending. Oil Drum has a nice rundown of truths and misconceptions about the summertime gas price spike. Especially solid is the explanation of the switch from winter to summer gasoline blends:

As gasoline evaporates, volatile organic compounds (VOC’s) enter the atmosphere and contribute to ozone formation. Gasoline’s propensity to evaporate is measured by Reid vapor pressure (RVP). In order to control VOC emissions, the Federal Clean Air Act Amendments of 1990 require that all gasoline be limited to an RVP maximum of 9.0 psi during the summer high ozone season, which the Environmental Protection Agency (EPA) established as running from June 1 to September 15. The Act also authorized the EPA to set more stringent standards for nonattainment areas. As a result, EPA limits areas designated as “high volatility non-attainment” to a maximum RVP of 7.8 psi during the high ozone season. Some States elected to require even more stringent restrictions to achieve local clean air goals, and require 7.2- and 7.0-psi gasolines.

Basically, since it’s hotter in the summer, you need a lower RVP to prevent your gasoline from vaporizing before combustion. As OD explains, winter blends incorporate butane as a blending agent, which is cheap but has an extremely high RVP rating; thus, summer blends face a higher marginal cost. In addition, the overall supply of gasoline bulges in the winter as the butane’s volume is added to the market. Of course, there is also the matter of increased demand during travel season.

However, I think the most economically interesting part of this regulation is the consequence of the variation from region to region:

More congested areas and hotter areas will tend to have a limit of 7.0 psig, while cooler climates generally opt for 7.8 psig. Some cooler climates don’t even require a reduction, and have a 9.0 psig limit throughout the summer…One of the disadvantages of having different requirements for different areas is that summer gasoline is less fungible. This can cause price imbalances in different areas, and sometimes prevents product from flowing from one area into another to ease the shortage.

I suspect that this helps explain why California summer gas prices always seem so out of control, even relative to the nationwide seasonal price increase.

Free Ride

Yesterday Greenwire had a story on Congress’s new WheelsForWellness program. The exact details of the program are still being worked out, but the general idea is to place bikes around the Hill that staffers can register to use for free. While this is a nice little gimmick, I’d really love to see DC go the way of Copenhagen, and offer free public bikes to all of us. This would be especially useful for DC tourists, as the Metro is really only practical for going long distances and the cab “system” is a joke.

Moving on, I’d just like to point out that John McCain called for a summer gas tax holiday in his economic policy speech yesterday. The man who self admittedly “doesn’t understand economics” is proving it to all of us by simultaneously calling for action on climate change and a suspension of gas taxes. I guess it’s easy to be a “maverick” when the media lets you have your cake and eat it too. What a joke.

Finally, with the Pope in town today I figured it’d be a good time to talk about the Popemobile. First of all, can you believe we call it that? Like the Batmobile. On to the vehicle. I had a hard time figuring out exactly what type of car the Pope’d be rollin in today. The picture on Wikipedia appears to be a suped up Mercedes-Benz 230 G with a giant tic-tac case mounted to the back.

While Benedict’s clearly got a bias towards ze Germans, I sure hope someone’s workin to put him in test version of the Volt.

Shhh, don’t tell Evan, I am going to post on the SPR

You only have to click here to see that I am not the resident SPR expert. But Evan is away on vacation this weekend, and I couldn’t let this go by:

Since current SPR additions are only 0.07 MBD (70,000 bbl/day), how much effect could foregoing them have on oil prices? Measured against 85 MBD, virtually none, but that’s not the relevant comparison. What really counts is the Mid-continent light sweet crude system.

…

With its three current royalty-in-kind swaps consisting of 58% sweet crude grades, according to a DOE spokesman I contacted this morning, the government has a 40,000 bbl/day lever with which to nudge the balance point of the physical WTI market by reselling the oil that would otherwise go into the SPR. Because that still only amounts to a few percent of actual WTI deliveries, I wouldn’t expect the market to drop by $10/bbl. But when you add the psychological impact of the government shifting its stance from buyer to seller–a net swing of 80,000 bbl/day–I wouldn’t be surprised to see a change in the speculative logic driving oil ever higher. That ought to be good for at least a few bucks per barrel, and a bit less exuberance going forward.

The basic argument as I read it is that the entire oil market is mostly resting on the back of the market for light sweet crude, and there is probably excessive speculation in the light sweet crude market. Pulling government support for even a tiny fraction of the market could scare off enough speculators to get prices to fall across the global oil market by more than you would initially suspect.

Also, Evan should get some credit. He has apparently leveraged his enormous influence through this blog to convince one of the presidential candidates to argue that we should suspend SPR purchases.

Independent truckin’: are their chips cashed in?

For all the talk I’ve heard about shipping costs going up with the price of fuel, I hadn’t really thought about the actual logistics of such a passthrough. In the trucking industry, it seems that owner-operators are paid by the mile, then expected to cover fuel and other costs. As diesel prices have shot up, independent drivers’ compensation has apparently not increased in kind, prompting a “loosely organized” informal slowdown/protest on major highways. Indeed, they have been footing the bill for the rest of us when it comes to rising fuel costs. From the Houston Chronicle:

“We can no longer haul their stuff for what they’re paying,” said David Santiago, 35, a trucker for the past 17 years. Santiago, like many of the more than 50 truckers gathered on a side street near the Port of Tampa, said he can’t support his family on what he makes. “If it wasn’t for my wife, we would have been bankrupt already,” he said.

Okay, understandable. So what can be done about it? Either companies are going to have to increase the price they pay independent operators, or fuel prices are going to have to decline somehow. Unfortunately, neither seems feasible at the moment:

Some other truckers, however, didn’t join the protests, saying they doubted a strike or mass demonstration would be effective because trucking companies are not on board and there is no central coordination.

“The oil company is the boss. What are we going to be able to do about it?” said Charles Rotenbarger, 49, a trucker from Columbus, Ohio, who was at a truck stop at Baldwin, Fla., about 20 miles west of Jacksonville. “The whole world economy is going to be controlled by the oil companies. There’s nothing we can do about it.”

Here we have a combination of collective action problems and lack of market power preventing the efficient passthrough of fuel costs to the consumer. The independent truckers apparently don’t have the coordination or sway to demand higher compensation as their costs go up. Marginal cost of supply went up, but market price isn’t rising in tandem as the oligopsonists hold it down.

So it looks like the only way to deal is to stabilize and even depress oil prices — that’ll stick it to the “boss”.

Some truckers, on CB radios and trucking Web sites, had called for a strike Tuesday to protest the high cost of diesel fuel, saying the action might pressure President Bush to stabilize prices by using the nation’s oil reserves.

It seems that America thinks the SPR can lower fuel prices, slice through marble, and strengthen your core in only 5 minutes a day for the low price of $99.99/barrel. No offense to Tony Little, Ron Popeil, and Byron Dorgan, but it probably can’t. Sadly, it’s a different world than it used to be, and the SPR just isn’t that big.

John Whitehead on the SPR

Responding to a claim by Congressional Democrats that (edit, left for posterity), John Whitehead over at EnvEcon thinks about the impact of the SPR fill and does a quick-and-dirty estimate of the drop in gas prices that would accompany a suspension of current policy. Key result:

Given the short run elasticity of .10, U.S. gas/oil consumption would need to fall by almost half to nudge gas prices down by $0.16/gallon.

In extremely vain fashion, here is a link to a very qualitative SPR post I wrote recently. John’s numbers back up my half-assed informal analysis and provide better context for scrutinizing simplistic anti-SPR arguments. As the GAO and I have pointed out, there are different reasons for re-examining current SPR fill policy that might hold more water (and less sweet crude).

GAO blasts DOE on SPR*

As the fill of the SPR is debated by Congress and the DOE, the GAO threw its hat in the ring. The Office’s report is critical of the cost-effectiveness of fill protocol. It makes three very reasonable suggestions:

1. Include some heavy crude in the SPR.

This is a complete no-brainer as far as I’m concerned. According to the report, around half of disruption-vulnerable U.S. refineries are incompatible with the light and medium crude currently held in the SPR. Running the wrong type of crude would result in about a 5% reduction in U.S. refining throughput, a significant loss during a supply disruption. Five percent is pretty bad, and certainly blunts the impact of any SPR release, but that’s for total refinery throughput. One refiner cited in the study claims that using exclusively SPR oil in its heavy crude unit would result in 11 percent less gasoline and 35 percent less diesel. To be fair, refineries are probably not going to be relying entirely on SPR crude, but you get the point.

There’s also the little matter that heavy crude costs about 10% less than light. So current policy has us buying more expensive crude oil that is only efficiently compatible with about 55% of likely affected U.S. refineries. Gold star for the GAO.

2. Use dollar-cost averaging to determine a purchase path instead of a constant quantity path.

The government has basically set a quantity and, as Sen. Dorgan is learning, is largely intractable regardless of market conditions. This means that even as prices soar above that magical $100 mark, the DOE is stubbornly purchasing the same monthly quantity as before. By using dollar-cost averaging, DOE basically gives itself a monthly SPR allowance. Thus, like a normal consumer, the DOE buys more oil when it’s cheap, and less when it’s expensive. This sounds good, but markets are tricky, and the oil market is quite volatile. So I quote the GAO:

We also ran simulations to estimate potential future cost savings from using a dollar-cost-averaging approach over 5 years and found that DOE could save money regardless of the price of oil as long as there is price volatility, and that the savings would be generally greater if oil prices were more volatile.

100 points to the GAO.

3. Purchase oil on the market instead of through royalty-in-kind arrangements.

First, this adds an unnecessary level of red tape to the SPR fill process. Since not all oil from RIK arrangements goes to the SPR, there is clearly already bureaucracy in place to sell RIK crude. But maybe selling off RIK crude and using the revenues to purchase the same amount of oil on the world market sounds inefficient and circuitous.

Well, unfortunately, the way the bid evaluation process works is not equivalent for market purchases versus RIK exchanges. Straight market purchases are considered conditional on general market trends, as well as the prices of SPR-suitable crude grades relative to other grades. In contrast, the RIK oil is exchanged for other oil for the SPR. The evaluation process focuses on whether DOE will receive oil of at least the same value as the RIK oil it is giving up. Thus, it ignores market trends and is vulnerable to exchanging at questionable times. The GAO report gives an example in which simultaneous bidding processes resulted in opposite outcomes: the cash process rejected Light Louisiana Sweet (LLS) at $67/bbl, whereas the exchange process bought LLS at a similar price. As you might have just concluded yourself, the cash process is also considerably more transparent. A for the GAO.

This report is quite readable, and well worth a look. But at first glance, it certainly seems that if the SPR fill process is to go on, the DOE and Interior would do well to implement the GAO’s suggestions. They would save money, improve the SPR’s effectiveness in the event of a disruption, and increase transparency.

Note: for great analysis of the fill/no fill debate, check out this post at Energy Outlook. Also read the post’s comments for some discussion of dollar-cost averaging by people who actually seem to know something about investment.

* I kind of wanted to see if I could write a title in which over 50% of the letters are in acronyms. Yes I could.

Assorted links

1. British Columbia is implementing a revenue-neutral carbon tax. Mike Moffatt is a fan.

2. Oil closed above $100 per barrel for the first time ever yesterday (in nominal terms). The WSJ Environmental Capital guys immediately called it speculation rather than fundamentals.

3. In the face of high fuel prices, residents in the Northeast U.S. are switching back to wood-burning stoves, but this move carries its own costs, particularly to local air quality.

4. Cameroon wants to rent a forest — preferably to conservationists — but doesn’t seem to have any takers. The article points out that they may be above the market-clearing price.

5. Ezra Klein praises density.

6. George Monbiot, writing about climate change policy, is offended that economists place a monetary value on human life, and that hence there is a chance “we would then find that it makes economic sense to kill people.” One of the Free Exchange bloggers defends the use of benefit-cost analysis, while Tim Haab provides a straightforward explanation and able defense of why economists place a value on life. (Hint: it’s because we all do — they’re called trade-offs.)

Should the US fill its SPR?

On the heels of yesterday’s post on a potential Canadian SPR, Sens. Dorgan and Wyden will introduce a bill to suspend fill of the SPR for one year or until oil prices fall to $50 or less (right…). According to Reuters:

Senate Democrats say the department’s plans are keeping U.S. crude oil and gasoline prices high, and on Wednesday will introduce legislation to delay plans to fill the SPR until prices fall.

The claim that the fill is keeping prices high is a bold one, as the fill plans to add 125,000 barrels/day, or 0.6% of the roughly 21 million barrels the US consumes daily. If we look at it as a share of total global consumption, it amounts to a less-than-whopping 0.15%.

Jeff Bingaman gave a different reason, but then fell back on the old faithful high price argument:

[Bingaman] told Energy Secretary Sam Bodman on Wednesday that it did not make sense to buy expensive oil for the emergency stockpile. “It seems odd to be spending a half-billion taxpayer dollars on activity that will help keep oil prices high,” Bingaman said at a hearing on the Energy Department budget.

The first half of the statement makes some sense. It is indeed more expensive to fill the SPR than it would have been in the recent past. However, making claims about the process significantly exacerbating the situation is either ignorant or disingenuous. I don’t honestly think we probably need to be increasing the size of the SPR to 1 billion barrels for some of the reasons I cited in the Canada post (e.g., crowd-out of private inventories), but it’s always alarming when politicians hijack economics to support whatever bill they’re pushing.

Should Canada build an SPR?

A joint report released this week by two think tanks called for Canada to establish its own SPR. As a net exporter of oil, Canada is not obligated to hold a particular level of stocks under the IEA emergency reserve program. However, the report argues that:

The IEA exemption for Canada is not warranted. NAFTA’s energy “proportionality clause” undercuts the logic behind the IEA’s exemption. Proportionality requires Canada, and Canada alone, to maintain its current share of energy exports to the United States, even if Canadians experience shortages. Mexico refused to sign this clause. Thus, until Canada demands, and gets, a “Mexican exemption” from the proportionality clause, not much oil from Western Canada and offshore Newfoundland can be redirected to meet Eastern Canadians’ needs.

This is an interesting argument, as Canada is exempt from requirements, despite the fact that most of its pipelines run North-South, thus leaving Eastern Canada vulnerable in the face of a short-term supply disruption. However, it jumps from proclaiming energy insecurity to touting the need for government stocks with few intermediate steps.

Many nations have set up reserves maintained by the private sector or via a quasi-governmental agency/corporation. This is generally done by requiring that all importers and/or refiners be required to hold a certain proportion of annual purchases or production in emergency stocks. These stocks are bound by law for release in the case of a declared supply emergency. This method is perhaps more efficient than a monolithic SPR (though there perhaps are economies of scale in storage), as it cuts out one more step in the process and also means that each refiner or importer can hold stocks of various refined products somewhat proportionally to production or purchase.

The cost-benefit balance of an SPR must account for the structure of the oil market. Oil is largely a fungible commodity, and stockdraw by any nation will have the desired effect on the world price for oil. Hence, coordinated draw under IEA and EU regulations will probably reduce the necessary size of a Canadian SPR. In addition, public stockholding might crowd private stockholding out of the market to some extent. If the private sector knows that the government will quell major supply disruptions, it has less incentive to hold inventories. Thus, putting a barrel of oil in a government SPR would probably increase total oil inventories by less than a full barrel. Finally, the effectiveness of emergency stocks is contingent on a government’s willingness and ability to release the oil at the right time. The mere presence of stocks probably stabilizes prices to some extent, but a drawdown has to happen quickly and convincingly in the event of a disruption.

Finally, an SPR must have proper infrastructure. One reason the U.S. SPR is somewhat feasible is because it is stored in underground salt caverns along the Gulf Coast in Texas and Louisiana (as well as proposed sites in Mississippi), near much of American refining capacity:

The report proposes a series of salt caverns in Lambdon County, Ontario, to cover that province’s allocation, but immediately notes that their excavation could be an environmental concern. In addition, any release from these caverns would probably not be able to travel far because of insufficient pipeline capacity and the costliness of shipping by rail. Also, due to political concerns, any SPR allocation for Quebec would likey have to be located within the province.

This is not to say that I think required Canadian emergency stocks are necessarily a bad idea. I just hope that if it comes to the planning stage, the government will take into account the factors I noted above. It’s easy to just fall into the meme of “energy security” without really thinking about how oil markets work. I appreciate that the purpose of this report is probably just to kickstart debate; however, a more thorough BCA should be undertaken before making any bold claims about a “need” for an SPR.

Stuff To Do

1. Go see There Will Be Blood. Seriously. It was awesome. Also, if you’re interested in the the history of energy/ oil (and haven’t already read Upton Sinclair’s novel) it’s a nice complement to broader histories like Yergin’s The Prize.
2. Listen to my boss, Dallas Burtraw, and several others testify before Congress tomorrow on carbon permit allocation. Should be live on www.globalwarming.house.gov.
3. Attend this Friday’s AEI Conference on Texas Electricity Recycling. Lynne Kiesling, of Knowledge Problem, and her co-author will be presenting chapters from their new book. I know that some of us will be there.

Just like Eliza Doolittle

Ever wonder how oil goes from crude to refined? Here is a clear and elementary explanation of the process as well as the basic chemical differences amongst various petroleum products.

Are high oil prices the result of a weak dollar?

Last Friday there was an editorial in the Wall Street Journal claiming that “the biggest factor” contributing to the upward trend in oil prices has been the weak dollar. I’ll post the whole thing below the fold for those who don’t have access to the WSJ. Essentially their argument can be seen in this chart:

I have to admit that I don’t understand a lot of this stuff, and there’s a pretty wide range of very strong opinions out there in the blogosphere. My initial thought was that this article overstates the certainty over the direction of causation. An increase in the price of imports, especially one’s we consume inelastically, would weaken the dollar. My boss pointed out that we’ve been importing lots of oil for decades, but what that chart shows is that real divergence coincides with the Iraq war and GOP fiscal policy. My only counter to that was that it also coincides with a remarkable spike in demand from China and India.

Theres a long literature out there on commodity prices and monetary policy (and I’m not even going to pretend to be up to speed). As an example, this Frankel paper claims that high real commodity prices signal that monetary policy is too loose. Which is essentially the WSJ’s point. Yet we’ve hardly had the “tight fiscal policy” the article mentions, and inflation is still reasonably low. Energy prices explicitly accounted for in the Fed’s targets, but the other commodities the article mentions are. So what gives?

Sorry for the rambling, uninformative post. I’m mainly looking for someone to explain this stuff to me

BP buries its head in the tar sands

An article in the Independent discusses two important trends in a global economy simultaneously adjusting to increasing marginality of oil stocks and demand for green products: tar sand extraction and corporate greenwashing. At the nexus of these lovely issues is British Beyond Petroleum. After a lengthy campaign to recast itself at the forefront of clean energy technology, BP is finally plunging its head into the Canadian tar sands. Apparently BP has gone Beyond Petroleum, and they didn’t like what they saw.

The economics behind the move are simple:

The company had shied away from involvement oil sands, until recently regarded as economically unviable and environmentally unpleasant. Lord Browne of Madingley, who was BP’s chief executive until May, sold its remaining Canadian tar sands interests in 1999 and declared as recently as 2004 that there were “tons of opportunities” beyond the sector. But as oil prices hover around the $100-per-barrel mark, Lord Browne’s successor, Tony Hayward, announced that BP has entered a joint venture with Husky Energy, owned by the Hong Kong based billionaire Li Ka-Shing, to develop a tar sands facility which will be capable of producing 200,000 barrels of crude a day by 2020. Mr Hayward made it clear that BP considered its investment was the start of a long-term presence in Alberta. He said: “BP’s move into oil sands is an opportunity to build a strategic, material position and the huge potential of Sunrise is the ideal entry point for BP into Canadian oil sands.”

Perhaps it’s wrong to cast BP as the bad guy in this situation. Moving from a green advertising campaign to investment in extremely dirty, marginal petro production might seem counterintuitive or even disingenuous and evil, but clearly BP thinks that the move is worth it. Few consumers will (a) know about the tar sand development, (b) know how damaging it is or, (c) care. Thus, BP can continue its green lovefest while engaging in one of the dirtier extraction activities around. If I’ve learned anything from studying economics, it’s that one can get angry about “bad” business practices that reflect self-interest, or one can figure out policies to harness that self-interest in pursuit of more desirable goals. With a few exceptions, a firm’s advertising and image are geared toward maximizing profits, not making Greenpeace’s Christmas card list.

In the article, Greenpeace’s quotes are imbued with the sorrow of a disillusioned child. It’s probably just a ploy to spread indignation to a broader group, but anyone out there who actually feels betrayed by BP is a fool. Did people really buy into the whole “Beyond Petroleum” thing? Honestly — Petroleum is half of the company’s name.

Still, this kind of attitude is just great:

A spokesman for BP added: “These are resources that would have been developed anyway.”

You know, if it’s inevitable, then I guess we’re lucky that such an environmentally-conscious company is in charge of the process.

Energy Demand Inelasticity Cartoon of the Day