Energy Independence: The American Future

Last week, the International Energy Association (IEA) predicted that the global community is merely five years away from witnessing the emergence of a new leader in oil production. That can hardly be welcome news to Saudi Arabia, of course, the world’s largest oil producer at the present time, or to Russia, its longstanding runner up.

So which nation is preparing to accede to the throne? Is it Canada, with its fields of oil sands in the western province of Alberta? Or Brazil, with its newly discovered wealth of off-shore crude? Or perhaps China, Vietnam, or the Philippines, with their recent discoveries in the South China Sea?

To the surprise of many industry analysts, the IEA predicted that the United States will soon become the world’s greatest oil producer. In addition, the Association forecast that America will supply all of its domestic energy and become a net exporter no later than the year 2030.

Imagine, if you can, a world in which the United States no longer needs to import oil from the Middle East, from Venezuela, or from any other nation. An American economic super power with a stable, secure, inexpensive, and solely domestic source of energy? It could well guarantee the extension of Uncle Sam’s global dominance throughout the 21st century.

Envious Rivals

Of course, America continues to compete with a wide variety of rivals for economic dominance in global affairs. Nevertheless, none of its rivals can visualize a future of energy self-sufficiency.

China, for instance, is aggressively continuing to develop relationships with African nations in order to ensure future access to energy resources. And as a result of the Fukushima nuclear power disaster, Japan continues to struggle with its reluctant transition from nuclear power to alternative sources of energy.

Of all of the major global economic powers, Germany appears to have made the most progress thus far in transitioning from imported fossil fuels to domestic renewable energy sources. But its green energy projects continue to be plagued by massive operating costs that require significant government subsidies.

In contrast, the IEA noted that new discoveries of natural gas fields in shale rock within the United States will likely supplement its surging oil field capacities and convert America from an energy importer into a fuel exporter. The world’s largest economy, an energy exporter? For American corporations and consumers, it certainly represents an enviable future.

The Global Markets

Considering the current configuration of the global energy markets, though, it is important to note that an energy independent America would not be invulnerable to market disruptions in other nations. Indeed, the price of oil is established in the global market place, and it is influenced by factors that influence supply and demand around the world.

That has been true since the middle of the last century, when seven global companies — known as the Seven Sisters — seized control of the supply and the price of oil. Then, in 1960, effective control of supply and price began to shift towards the governments of oil producing nations when Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela formed the Organization of the Petroleum Exporting Countries (OPEC).

OPEC certainly does not exert full control over all global oil prices; West Texas Intermediate (WTI) crude oil, for instance, is traded as a commodity on the Chicago Mercantile Exchange (CME). Nevertheless, because traders and other investors can buy and sell most of the varieties of oil (as well as futures and other derivatives) that are produced around the world, the market price of oil that is both produced and consumed in the United States is affected by industry events elsewhere.

The Isolation Option

The past few years have been markedly turbulent ones for the global economy, of course, with once-reliable market pricing mechanisms struggling to adapt to new conditions. Might an energy-independent America be tempted to withdraw its oil and gas resources from the global markets and isolate itself from the price effects of external supply disruptions?

The scenario is not an implausible one. After all, domestic energy producers in the United States are already prohibited by law from selling large amounts of oil and gas resources to customers overseas. And conservative Republican politicians such as Ron Paul have long advocated for the dismantling of global market institutions such as the Federal Reserve Bank of the United States.

Likewise, many global financial analysts believe that the monetary zone of the European Union is destined to splinter because of centrifugal forces that are pulling apart nations like Germany and Greece. If the world’s financial markets fracture into national entities, the world’s energy markets may do so as well.

Would an American economy with a self-sufficient energy supply and a domestically controlled market mechanism be able to survive on its own? Conversely, would the rest of the global economy be able to survive without it?

These may represent mere rhetorical questions at the present time. In the near future, though, they may become immensely important policy issues.

Look Out, OPEC: America Is Exporting Fuel Again!

Was there anything about the condition of American society in the year 1949 that still exists today?

Very little actually comes to mind. There was, for instance, no interstate highway system in 1949; the government legislation that authorized its construction would not emerge until 1956. And the entire nation only owned two million television sets in 1949, with more than one third of them clustered in New York City. Furthermore, the minimum wage was a scant 75 cents an hour.

1949 was also the final year of a period of time in which the United States occupied a global role as a net exporter of fuel. Drilling wells in Pennsylvania, Texas, Oklahoma, and other states produced the crude oil that was then refined into fuel in the United States. The global economy, still rebuilding from the devastation of the Second World War, eagerly bought fuel from American suppliers.

Beginning in 1950, though, the American economy expanded to the point where the United States became a net importer of fuel. It then remained a net importer for the next six decades …

until, surprisingly, this year.

Supply and Demand

Why is the total amount of American fuel exports suddenly exceeding its total imports for the first time in sixty two years? As is the case with most aspects of our capitalist economy, the answer to this question can be described as a function of supply and demand.

For starters, American demand for fuel has declined for a pair of noteworthy reasons. The debilitating economic recession, and subsequent tepid recovery, have depressed economic activity and thus suppressed natural levels of demand. And numerous technological innovations, such as the introduction of electric automobiles that utilize little or no gasoline, have decreased America’s thirst for imported fuel as well.

Perhaps more surprisingly, the American production of recoverable energy assets has increased markedly during the past few years. Oil and gas production remains high in the United States, despite environmental concerns that were raised during last year’s BP’s Deepwater Horizon catastrophe. And new technologies are allowing energy producers to extract natural gas from shale rock in such novel locations as Arkansas and Pennsylvania; even New York State expects to initiate extraction activities in the near future.

With fuel supply up and fuel demand down, and with developing nations like China thirsty for energy products, it was probably inevitable that the American fuel trade gap between imports and exports would shrink. Nevertheless, very few pundits had foreseen that the United States would quite literally become a net fuel exporter.

Upstream vs. Downstream

Should OPEC become worried? Is America about to challenge it for control of the energy markets?

Well … not quite. After all, there is a major difference between upstream energy production and downstream production. Upstream products are extracted from the earth in their natural states. Crude oil, for instance, is an upstream product. Natural gas, embedded in shale rock, is an upstream product as well.

Downstream products, on the other hand, are energy materials that have been refined and packaged for use by consumers. Motor vehicle gasoline, for example, is a downstream product. So is propane oil, and so is firewood, for that matter.

The distinction between upstream and downstream products is a bit murkier when our attention turns to renewable energy sources. One might be tempted to define the wind and the water itself as upstream products, and the electricity produced by wind mills and hydro power plants as downstream products.

So America’s shale gas production would indeed represent an upstream activity that competes directly with OPEC’s upstream crude oil production business. But fuel is a downstream product, and thus America’s re-emergence as a net fuel exporter is no direct threat to OPEC.

Why Can’t We Be Friends?

There must necessarily, of course, be a direct relationship between upstream and downstream firms. Namely, upstream firms must sell their extracted products to downstream firms, which in turn must refine and package them for sale at the retail level. In other words, downstream firms must function as the “middle men” who represent the customers of the upstream firms.

So, if that’s true, then downstream fuel producers in nations like the United States are still reliant on (and are thus vulnerable to) upstream suppliers like OPEC. Conversely, crude oil suppliers like Iran are still reliant on (and, again, are thus vulnerable to) downstream customers like the United States.

So the re-emergence of the United States as a net exporter of fuel does not, regrettably, imply that the goal of American energy independence — as initially defined by President Richard Nixon during the Arab oil embargo of the 1970s — is about to become a reality. Nevertheless, as long as American downstream producers can continue to secure deliveries from their upstream providers, the United States should be able to avoid the prospect of fuel shortages during the upcoming winter months.

Made In America: The Russians Are Coming!

Do you recall the 1969 Union Oil disaster that ruined the coastline of Santa Barbara, California? Or the 1989 oil spill by the Exxon Valdez that spoiled the pristine waters of Prince William Sound, Alaska? How about last year’s BP’s Deepwater Horizon “gusher” that stained the ecosystem of the Gulf of Mexico?

All of these crises — and smaller ones, too, such as this summer’s Yellowstone River pipeline rupture by Exxon Mobil in Montana — were expected to ruin the prospects of energy producers within the United States. The American public, some believed, would not tolerate any future ecological risks after experiencing such crises and witnessing such environmental damage.

A few weeks ago, though, the Democratic governor of a quintessentially liberal northeastern American state surprised the energy industry by deciding to approve a highly controversial extraction procedure. And just last week, Exxon Mobil unexpectedly agreed to grant a former political adversary the option to operate energy production fields on American soil.

If I Can Make It There …

Recently, as we entered the peak summer energy season in the United States, New York State Governor Andrew Cuomo approved the use of hydrofracking at natural gas production facilities. The technique is considered controversial because it involves the forcible injection of highly pressurized water into the deep ground to free up gas resources. Officials in Arkansas and other states suspect that the activity is responsible for causing or exacerbating earthquakes and damaging water tables; some regulators have thus suspended or prohibited the practice on environmental grounds.

New York State, of course, is one of the birthplaces of the modern environmental movement, having produced such statesmen as President Theodore Roosevelt, who greatly expanded the national parks system. Furthermore, Governor Cuomo is the scion of former New York Governor Mario Cuomo, himself a renowned leader of liberal causes. Thus, few thought that an environmentally controversial energy production technique would meet with Cuomo’s approval, but the Governor decided that the potential economic benefits of hydrofracking were simply too attractive to ignore any longer.

New York State has not yet authorized any specific energy producers to operate hydrofracking facilities within its borders. Such firms may find, though, that — to paraphrase Frank Sinatra — if hydrofracking can “make it” in New York, it can indeed “make it” in other regions of the United States as well. In addition, Governor Cuomo may find that many firms based outside of the United States may be interested in pursuing the business opportunity alongside domestic corporations.

Venezuela, China … and Now Russia

The American energy industry, of course, operates within a global marketplace. For instance, even though BP’s American marketing campaign insists that its initials stand for Beyond Petroleum, Americans understand that the firm is based in London and has traditionally used the name British Petroleum around the world. Likewise, it is no secret that retail gas stations on American roads that are emblazoned with the Shell insignia are affiliated with the European firm Royal Dutch Shell.

Other global firms that operate within the United States prefer to maintain a more subtle presence. For instance, it is difficult to tell from Citgo’s star spangled, all-American marketing material that it is actually owned by the national oil company of Venezuela. And although the Chinese oil company Cnooc does not sell gasoline directly to American consumers, it has now received the requisite approval to engage in a major American joint venture with Chesapeake Energy after having been rebuffed in its attempts to purchase Unocal several years ago.

Venezuela and China are generally not considered to be close diplomatic or economic allies of the United States; neither, of course, is Russia. Nevertheless, with their recent groundbreaking agreement, Exxon Mobil and the Russian energy colossus Rosneft have agreed to travel down the road of economic integration together.

From The Arctic To America

Last week, Exxon Mobil and Rosneft finalized a joint operating agreement that extends from the United States to Russia. Specifically, Exxon agreed to assist Rosneft in the development of several huge and technologically challenging oil fields in the remote stretches of the frozen Arctic Ocean; in return, Rosneft received the option to participate in the development of various energy fields on American soil.

The Russian Prime Minister Vladimir Putin personally attended the ceremony that marked the signing of the agreement. Because 75% of Rosneft is controlled by the Russian government, the corporate relationship makes America’s former adversary an important ally of the United States in the development and implementation of its national energy policy.

Which event is the more surprising one: Governor Andrew Cuomo becoming an ally of hydrofracking companies, or the federal government of Russia becoming an energy production partner of Exxon Mobil on American soil through its ownership interest in Rosneft? Each situation may appear to be groundbreaking from an historical perspective, and yet each exemplifies the rapidly evolving set of political and economic alliances in the global energy industry.

Commodities Crash: A Market Economist’s Nightmare

Do you remember the first great internet investment bubble of the late 1990s?

Hundreds of millions of dollars were invested in astonishingly flimsy firms like Pets.com and drkoop.com. The NASDAQ market, host to many of the Initial Public Offerings (IPOs) that attracted funds to these companies, witnessed its composite index quintuple in value in just six brief years between 1995 (when it surpassed 1,000 for the first time) and 2001. But then, like all bubbles, the index valuation crashed, collapsing back to a value slightly above 1,100 by late 2002.

At the time of the crash, many American investors swore that they would never again be beguiled by future bubble markets, promising to restrict their funding decisions to more stable industry sectors. And yet, just a few years later, rock-bottom mortgage interest rates created a mammoth real estate bubble, supported by the irrational proposition that home investment valuations in the United States could never decline in absolute terms. Nevertheless, when that bubble burst in late 2008, it nearly brought the entire global economy down with it.

Have global investors learned their lessons about avoiding manic bubbles? Apparently not! In fact, yet another investment sector appeared to gyrate towards a crash last week, one so universally significant that it is giving market economists nightmares.

Silver and Gold and Oil, Oh My!

The sound of the largest crash last week came from the silver market. The value of silver, having soared by 57% during the first four months of 2011, suddenly reversed direction and fell more than 25% during the first five trading days of May.

And yet gold, too, went into a tailspin. After having jumped from $1,000 to $1,541 between September 2009 and April 2011, it suddenly slumped by close to 5% during the most recent four trading days. And oil, having soared from $33 per barrel in January 2009 to levels beyond $100 per barrel in February 2011, fell by almost 15% last week.

Pundits blamed these sudden lurches in commodity values on investment speculators who buy and sell vast quantities of these materials on the global markets. Unfortunately, though, firms that use these commodities for industrial and consumer applications must purchase them on the same global markets. Inevitably, when prices fluctuate so dramatically, corporate planning activities for the future — as well as their operations activities in the present — become unmanageable.

Ripple Effects

Gold, for instance, is more than just a glittering metal that is shaped into rings and necklaces. It is also an excellent conductor of electricity, and is therefore employed as an industrial component in many types of electronics equipment. Manufacturers of computers and cell phones thus feel their profits pinched whenever speculators drive up the cost of the precious commodity.

Silver, as well, is a strong conductor of electricity and heat, and is able to withstand extreme variations in temperature. Manufacturers of conventional batteries and solar energy panels rely heavily on it, and likewise see their profits vanish whenever the cost of silver increases. And in the nascent alternative energy industry, where losses are common even under the best of conditions, such cost bubbles can drive development projects (and entire firms) into bankruptcy.

Sharp increases in the cost of crude oil can, likewise, ripple through the entire global economy. Airlines simply retreat from markets that become impossible to serve profitably, cutting off tourist areas and business markets from their constituents. And, on a personal level, economically strapped families in cold weather states like Massachusetts and Michigan are forced to wonder how they’ll find the funds to heat their homes through frigid northern winters.

The Cost of Uncertainty

As market economists know, the true costs of such massive fluctuations in commodity values extend far beyond the expenditures that are required to procure the materials themselves. Indeed, the greatest costs of all may emanate from the uncertainty that is generated by such fluctuations, an effect that paralyzes commercial activity and drives up the cost of capital.

When the Chief Financial Officers of alternative energy firms witness the cost of traditional crude oil more than triple within two years, and then drop by almost 15% in a single week, they cannot help but wonder whether that cost might continue plummeting in the near future. If such declines actually continue, the cost of oil-based energy would likely fall so low as to make the cost of alternative energy unattractive by comparison.

Furthermore, banks and investors would perceive such alternative producers in a far more risky light, and would raise their interest and dividend demands accordingly. In other words, the cost of obtaining investment capital at alternative energy firms would soar at the very moment that their competitors’ operating costs would fall.

The result would be paralysis in the alternative energy sector, thereby locking our economy into the perpetual boom-and-bust price cycles of the traditional commodities sector. Can we afford to continue living with such outcomes? Perhaps not, because without stability in the price levels of commodities and other raw materials, no business can feel comfortable investing in growth plans for the future.

Variance Analysis: Whom To Blame At Southwest?

What a difference a half-year makes! As recently as July 2008, the mass market uber-tabloid USA Today was praising Southwest Airlines for achieving its 69th consecutive quarter of operating profit. That’s a remarkable continuing achievement, one that the USA Today attributed to Southwest’s foresight in using hedging contracts to lock in low fuel prices during an era of skyrocketing energy costs.

Today, though, the direction of fuel price trends has shifted dramatically. What seemed to be prescient foresight on the part of Southwest now appears, with 20/20 hindsight, to have been a strategic error. By hedging at a price level that is now well above the market cost of fuel, Southwest incurred financial costs that currently exceed its total operating profits. Their CFO recently, and perhaps somewhat ruefully, confirmed to analysts “We do not believe it is the time to be long on energy.

So what was considered a brilliant fiscal strategy last July is now perceived as a costly and unnecessary expenditure. How should Southwest determine whether any one should be blamed for its current difficulties?

Two Variables … Umm, Make That Three

The first important point to recognize in answering this question is that there are at least two variables that must be considered when managing fuel costs. One is the price spent on each barrel on fuel; the other is the quantity of fuel used.

That may be an obvious fact, but its implications are fairly subtle because decisions about price and quantity are intertwined in complex ways. For instance, let’s assume that holiday season congestion at major airports is expected to drive up the volume of fuel consumed on airplane taxiways. Well, if the members of an airline’s management team are certain that the consumption quantity of fuel will spike up next month, they might be willing to take more aggressive risks to keep the price per barrel low. Conversely, in times of declining fuel usage, the airline’s willingness to engage in aggressive price hedging activities might wane.

Furthermore, these two variables – price and quantity – often evolve into three variables when companies lock in guaranteed energy prices well in advance. Let’s assume, for instance, that an airline originally budgets $10 billion to buy 200 million barrels @ $50 per barrel. Let’s also assume that three different individuals, working independently of each other, make three different decisions: (a) the CFO hedges all oil purchases to lock in a rate of $45 per barrel, (b) the COO believes that fuel usage will likely spike upwards and authorizes the purchase of 250 million barrels, and (c) the Engineering Department finds a way to run jet engines at a highly fuel-efficient level during peak times, thereby holding fuel usage to 220 million barrels.

So what happens? Assuming the market price of fuel remains above $45 per barrel, the actual cost of purchasing 250 million barrels @ $45 will be $11.25 billion. Thus, the airline will overspend its $10 billion fuel budget by $1.25 billion, and three people – the CFO, COO, and Engineering Department Director – will share responsibility for this unfavorable variance.

So … Who’s To Blame?

An impatient Board of Directors might rush to judgment and hold all three individuals jointly responsible for overspending the cost budget by $1.25 billion. However, a “back of the envelope” set of variance calculations would caution them to take a more nuanced approach:

Based on this analysis, the CFO should actually be praised and not blamed for slashing a potential $2.5 billion budget shortfall in half by saving the firm $1.25 billion through effective hedging mechanisms. And what about the COO? (S)he should indeed be blamed for ordering 30 million barrels in excess of what was actually used, but not blamed for the full 50 million barrel difference between the volume originally budgeted and the volume eventually used.

So who gets the blame for the remaining 20 million barrel difference between the 200 million barrels in the original purchase budget and the 220 million barrels actually used? That’s hard to say; only an in-depth review of internal company records would be able to answer that question. Perhaps the COO’s analysts who prepared the original budget failed to reach out to the Engineering Department for a realistic estimate. Or perhaps the engineers neglected to provide the analysts with accurate information. Either way, it would be terribly misleading to rely on the overall $1.25 billion variance to make management decisions without considering its three core components separately.

A Failure To Communicate

Without knowing the situation that existed within Southwest during the past year, it would be unfair to blame the sudden and unexpected ineffectiveness of Southwest’s fuel cost management strategy on any single party. You can be sure, though, that any organization facing volatile price and volume factors will use variance analysis to track performance and address such issues.

To paraphrase Paul Newman’s nemesis in the 1967 film Cool Hand Luke, organizations that face huge budget variances often find that “what we have here is (a) failure to communicate.” Look again at the preceding hypothetical example. Had the COO and Engineering Department simply communicated with each other, the COO might have ordered 220 million barrels instead of 250 million barrels, and his $1.5 billion unfavorable variance might have shrunk to zero. Heck, the firm would thus have paid $9.9 billion for 220 million barrels @ $45, and therefore would have underspent its original budget of $10 billion!

That’s the power of variance analysis; in addition to identifying the sources of budget problems, it also suggests ways to fix ’em. Sometimes, sadly enough, we learn that multi-billion dollar variances could have been prevented by simple intra-firm communication techniques.