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.

Hurricane Sandy: Debating Economics

Hurricane Sandy swept across the northeastern and midwestern regions of the United States last week, destroying thousands of homes and rendering more than eight million individuals without electrical power. The news might become even more grim this week, as a midweek storm threatens to dump several inches of snow on homes that still remain without any heat or light.

Although the immediate priority for government officials is the restoration of the existing power grid, long term planners are beginning to suggest innovative approaches to strengthen the region’s energy infrastructure. After all, such “storms of the century” are attacking the region with more regularity, with Hurricane Irene causing massive damage on August 27, 2011, and an unnamed nor’easter dumping over 21 inches of snow on New York State on Halloween Day, just two months later.

Some commentators attribute the recent onslaught of freakish weather to climate change that is caused by our own carbon omissions. Others believe that the region might be experiencing a naturally occurring shift in climate cycles. All would undoubtedly agree, though, that a new long term strategy may be needed to confront this meteorological threat.

Distributed Generation

During the past few years, government officials in Connecticut and New York State (as well as in California) have studied the possibility of developing innovative programs to address climate change. Connecticut, in particular, has aggressively launched a pilot program to develop clusters of microgrids at the local level.

Microgrids? What are microgrids? The term refers to relatively tiny power generation systems that serve very limited geographic areas. When a large region relies on many small microgrids instead of a single massive facility to produce power for its entire population, it is employing a strategy known as distributed generation to serve the needs of its citizens.

A few years ago, for instance, Toshiba developed a proposal to build and maintain a miniscule nuclear power plant for Galena, Alaska, a village with a population of 470 citizens. Although safety and other concerns led to the discontinuation of the project, such microgrids could nevertheless serve as back-up systems in the event of a massive regional power failure.

Economics: Theory Vs. Theory

Is this a good idea or a bad idea? Unfortunately, the discipline of economics does not offer us a clear answer to this question. Instead, it provides a pair of conflicting theories, one in support of each position.

On the one hand, the law of economies of scale would imply that a single large regional facility would be far more cost-efficient than a large number of tiny facilities. In other words, according to this law of economics, a widespread microgridding strategy might drive up the costs of generating power to unsustainable levels.

On the other hand, clusters of microgrid facilities would not necessarily focus exclusively on supporting the primary regional power grid during times of crisis. The small generation plants could produce power during times of normal operations as well. In fact, they could easily feed power into the primary grid on a continuous basis, and even compete with each other to sell energy to local customers.

A large number of small suppliers, competing on the basis of cost, service quality, reliability, and other factors? Classical economists would call such a model capitalism. Although each individual supplier may fail to achieve significant economies of scale within such a system, the “invisible hand” of market competition — as first described by Adam Smith in his classic text The Wealth of Nations — would nevertheless regulate the industry and produce optimal results.

From Banking To Health Care

In a sense, this “micro vs. macro” debate over energy production and distribution strategies is similar to policy disputes that are raging across many other industries. In the banking sector, for instance, many industry experts have noted that the Dodd Frank regulatory structures that were developed after the 2008 global financial crisis may have actu­ally punished relatively healthy regional banks, while the “too big to fail” institutions that precipitated the collapse have grown even larger in size.

Likewise, in the American health care sector, arguments continue to flare about whether the provisions of the Affordable Care Act (i.e. “Obama Care”) will save the system or destroy it. Whether or not the Act is implemented in its current form, hospital systems and insurance companies in the United States are likely to continue with their consolidation activities, hoping that the effects of economies of scale will outweigh the impact of diminished competition.

Regrettably, such economic debates will not benefit the victims of Hurricane Sandy, who are awaiting next week’s approaching snow storm with immense trepidation. Nevertheless, in consideration of their plight, our government officials may wish to consider a microgridding strategy as a means of building additional power capacity. After all, in this situation, the economic cost of service redundancy may be outweighed by the human (and humane) benefit of financing it.

Gasoline Prices: Driving Economic Prosperity?

The American economy has been stuck in a rut for a very, very long time. The unemployment rate, for instance, has been lodged above 8% since February 2009; it has remained there throughout President Obama’s term of office. And the Dow Jones Industrial Average has yet to surpass the 14,000 point level that it first reached in the pre-crash days of July 2007.

At first glance, last week’s news of a retail sales increase appeared to represent a rare signal of hope. But then it was reported that the increase was attributable, in large part, to a recent surge in the retail price of commercial gasoline.

The rise in the price of gas is particularly surprising, occurring in the post-Labor Day period when prices customarily decline as Americans return to work from their summer driving vacations. But is it possible that higher gasoline prices might actually help lift the United States out of its economic rut?

An Addiction To Imported Fuel

Traditionally, high gasoline prices have been detrimental to the American economy. The spike in energy costs during the 1970s, for instance, wreaked havoc on the financial security of the United States; it led President Jimmy Carter to declare that the development of a national energy policy represented the moral equivalent of war.

But that was a time when the American energy industry was focused on the importation of fossil fuels from foreign sources. Under such circumstances, any increase in the price of fuel would inevitably draw funds away from alternative domestic uses and fuel the profits of foreign providers.

For a while, America’s domestic nuclear power industry appeared to offer a home-grown solution to the nation’s addiction to foreign fuels. But the specter of nuclear disaster that was imposed on the nation’s psyche by the Three Mile Island crisis in 1979, stoked by films such as The China Syndrome that year, locked the American energy industry into a strategy of importation.

Energy Independence

So how has the American economy evolved during the past few decades? Why might higher fuel prices actually trigger an increase in domestic energy output, and ultimately lead to economic prosperity, today?

A primary reason, first and foremost, is that the United States is now producing a significant amount of energy resources to meet its own domestic needs. North Dakota has surged past Alaska to become the nation’s second largest energy provider, trailing only Texas. Pennsylvania, a major producer of crude oil in the late 1800s, is again producing energy resources with the use of fracking technologies and methods. And soon, the southern tier of New York State may begin doing so as well.

Furthermore, the Canadian province of Alberta has also recently become a major producer of fossil fuels. Given the extensive integration of the national economies of the United States and Canada, additional upstream energy activity in the Albertan region inevitably stimulates the economies of the northern American states too.

These developments have prompted Republican Presidential candidate Mitt Romney to declare that North America would achieve “energy independence” by his prospective eighth year in office, i.e. by the year 2020. Although some analysts believe that full energy independence may not necessarily represent an achievable (or perhaps even a desirable) goal, most do acknowledge that the emerging domestic energy industry is strengthened by higher energy prices.

A Gas Tax For The Deficit

High fuel prices generate indirect benefits as well. When the costs of fossil fuels are very high, the (generally always high) costs of renewable energy begin to represent competitive alternatives in comparative terms, and American consumers and businesses shift to these new “green” technologies.

The demand for solar panels, for instance, has increased in tandem with the recent spike in the costs of oil and gasoline. Although American panel manufacturers like the ill-fated Solyndra have yielded market share to Chinese producers lately, all panels (even those manufactured in Asia) require installation and maintenance in the United States, necessitating new jobs for the American economy.

Some well known commentators are actually advocating for higher retail taxes if the cost of gasoline drops back towards historical norms. Thomas Friedman, a global columnist for the New York Times and the author of the book The World Is Flat, has repeatedly called for an American taxation policy that imposes a retail gasoline surcharge of $1.00 and then applies all government revenues to reductions in the federal budget deficit. The United States, interestingly, has never paid a tax that is explicitly designed to reduce its accumulated debt.

Considering the aversion of America’s Republican Party to any new streams of taxation, it is unlikely that Americans will experience a national $1.00 per gallon gasoline tax at any time in the foreseeable future. Nevertheless, they shouldn’t be surprised if the recent surge in retail gasoline prices eventually produces some unexpected (and yet quite welcome) benefits for the American economy.

The Gulf Oil Spill: A New Black Swan?

Almost two full weeks have passed since Hurricane Isaac ravaged the Gulf Coast of the United States. Although the new levees that were constructed as a response to the Hurricane Katrina disaster successfully protected New Orleans against devastation this year, the neighboring Plaquemines Parish and many other communities were devastated by Isaac’s destructive power.

Many meteorologists predicted that the hurricane’s devastating winds and lashing rains would destroy buildings, collapse electrical power lines, and flood entire communities. But few anticipated that the storm would also bring forth an unwelcome reminder of another recent catastrophe.

In the wake of Isaac’s path, massive globs of oil and tar washed up on Gulf Coast beaches and shorelines. And this past weekend, federal government investigators confirmed that the toxic material had been lurking in the water nearby since BP’s Deepwater Horizon oil spill in 2010.

Chemicals and Bacteria

One of most harmful effects of an oil spill is the damage that the spilled product itself inflicts on the natural environment. The 1989 Exxon Valdez oil spill in Alaska’s Prince William Sound, for instance, released 250,000 barrels of oil into the water, leading to the deaths of thousands of sea animals and well over 100,000 birds.

Just as worrisome, though, is the fact that much of the spilled Valdez oil was not recovered during clean-up activities. Instead, significant quantities remain on the floor of the Sound and under the topical sand and soil of the shoreline, where the toxicity of the material continues to damage the environment.

BP’s Deepwater Horizon disaster actually disgorged far more oil into the natural environment than did the Exxon Valdez event. Up to 4.9 million barrels of oil was spewed directly into the Gulf of Mexico in 2010; it entered an eco-system that was already under stress from industrial development and climate change.

Geologists have noted that chemical dispersants successfully dissipated much of the Gulf oil, and at the time, they hoped that warm water bacteria would devour the rest of it. Nevertheless, the sudden emergence of the oil and tar after Hurricane Isaac was a sober reminder that large quantities of BP’s spilled oil still remain in the water.

An Insurance Challenge

In most business sectors, the risk of industrial accidents can be managed through the purchase of property insurance. An automobile manufacturer in the American South, for instance, can purchase a hurricane damage rider on its insurance policy; its annual premium cost would be established by the meteorological probability that a hurricane would hit the factory, as well as by the estimated damage that would occur as a result of the weather event.

In the event of a loss, after the hurricane passes, the insurer would promptly inspect the wreckage and then issue a check to reimburse the automobile manufacturer. But in the case of the BP oil spill, the environmental damage is continuing to occur many years after the primary catastrophic event. And the substance that is causing the damage is not readily observable (and thus is not easily quantifiable) while it lurks on the ocean floor and under the shoreline soil.

Furthermore, there is no consensus about the method that should be utilized to define and then quantify the insurable loss itself. BP, for instance, has already invested billions of dollars in the Gulf Coast region to restore its seafood and tourism industries. If the emergence of additional pollutants sets back progress in these sectors, should BP’s “sunk cost” restoration investments be treated as insurable losses? Or should they simply be regarded as write-offs of failed expenditures?

The Black Swan

In the field of insurance, the phrase “black swan event” refers to a situation where an extremely improbable loss of great magnitude has struck an organization. Because of the improbability of the event, the organization is likely to be uninsured because its insurance company is likely unable to determine an appropriate premium cost for a coverage policy.

However, the oil related environmental damage from the Hurricane Isaac event was, in retrospect, not improbable at all. Small quantities of oil and tar having been washing ashore after every rain storm, and thus large quantities of such pollutants should have been expected to wash ashore after major hurricanes.

Indeed, although actuaries may be challenged to define the extent of the insurable loss of such events, they should not find it difficult to estimate the probabilities of occurrence. The National Weather Service of the United States has been studying the incidence rates of destructive weather events since it was first created in 1870.

Environmentalists may be disheartened by the emergence and increasing prevalence of post-oil spill pollution clauses in the property insurance policies of upstream industrial energy organizations. Nevertheless, such clauses may be appropriate in an era when deep sea drilling, hydro-fracking, and other risky methods of extraction must be utilized to produce energy resources for an increasingly restive world.

Fracking: A Metaphor of Decline

“We’re in decline.”

It was a dramatic statement by an American political leader, one unvarnished by politically correct posturing or knee-jerk optimism. And it was verbalized by one of the most respected public figures in the United States.

Former Florida Governor Jeb Bush offered the comment during an interview in which he also opined that Republican icon Ronald Reagan (as well as his own father, President George H.W. Bush) would struggle to find a role within today’s Republican party. Although the political pundits focused on his opinion regarding Reagan, others were struck by his prognosis of the nation’s fiscal health.

Meanwhile, television viewers who were searching for tales of America’s economic prowess discovered the resurrection of a classic show about the world of American business. New episodes of Dallas, the oil industry saga that was broadcast on the CBS television network from 1978 to 1991, suddenly reappeared on TNT cable television with actors Larry Hagman, Patrick Duffy, and Linda Gray reprising their original roles as JR, Bobby, and Sue Ellen Ewing.

34 Years Later

Fans of the original television show engaged in extended online discussions about how the three original characters have changed during the 34 years that have elapsed since the program’s initial premiere. Likewise, we can discuss the evolution of the show’s underlying assumptions about the American economy to observe how our society has evolved as well.

For instance, the original Ewing Oil of 1978 was a family owned firm that focused primarily on developing land-based energy projects in the United States. Ewing family funds were also invested in Texas based ranching, farming, and media operations, thereby maintaining a domestic focus and avoiding any foreign entanglements.

Were there any exceptions to this unified American perspective? During the third season, JR Ewing did briefly invest $200 million in an Asian oil operation. But the diversion did not last long because local government regulators nationalized the energy fields, though only after the crafty JR obtained insider information about the impending nationalization and unloaded Ewing’s ownership interest on his unsuspecting business rivals!

In the contemporary version of the series, however, there is no such emphasis on domestic American business strategies. Christopher Ewing’s primary focus, in fact, is a methane gas operation off the coast of China. And John Ross Ewing’s efforts to develop fracking operations on the land under the family’s Southfork ranch is considered an environmental degradation by his extended family.

From Southfork to the Southern Tier

This very fracking controversy, of course, is currently playing out across the United States. Governor Andrew Cuomo of New York, for example, recently restricted the controversial production activity to the economically depressed Southern Tier of the Empire State after deciding initially to permit the technique on a statewide basis.

His recent restrictive decision satisfied no one. Critics of fracking predicted that the technique would pollute the state’s water supply, while proponents retorted that a geographically narrow production region would deter energy companies from making economically profitable investments.

Was Cuomo’s decision reflective of a state in decline? Some might opine that a state in a position of ascendancy would legalize fracking and then search energetically for technological solutions to its complications; others might opine that an ascendant society would prohibit the practice and then search energetically for replacement sources of energy. Cuomo’s compromise solution, regrettably, does not appear to match either profile.

The Metaphor of Fractures

Interestingly, John Ross Ewing’s focus on fracking activities may well serve as a metaphor for the challenges that face American society. Fracking itself is a process whereby pressurized fluids are blasted into deep underground rock formations, fracturing the earth and thus freeing the energy deposits from the soil.

In a sense, the Ewing family of Dallas has been fractured throughout its 34 year history in the world of television. And the television audience itself has grown increasingly fractured during the past three or four decades as well. Although it was possible for the iconic “Who Shot JR?” cliffhanger episode of the third season of the original show to attract an estimated 41.5 million households, the subsequent splintering of the American public among hundreds of cable and web based television shows makes such a unified television audience impossible today.

In a sense, the fragmentation of the contemporary American television audience reflects the type of social fracturing that Jeb Bush had in mind when he described the United States as a nation in decline. The same centrifugal social forces that are pulling American television viewers into segregated networks and shows are likewise isolating them into disparate political cliques, making compromise unlikely and political agreements impossible.

The result? Most critics have expressed doubt that the contemporary version of Dallas will be able to find its legs and ascend to the top of the television world. Likewise, there are many skeptics who are expressing doubt that American society will be able to reach consensus on its most pressing challenges and reverse its trajectory of decline.

Delta Airlines: Welcome to the Oil Business!

At first blush, it appeared to be an April Fool’s Day prank. A satirical, mock corporate announcement, one that couldn’t possibly be true.

What was the announcement? It was a statement, supposedly issued by “people familiar with the matter” at Delta Airlines, that the firm was “seriously thinking” about an opportunity to enter the oil business by purchasing a 185,000 barrel per day oil refinery from Conoco Phillips. Although the facility has been idle since October 2011, the mysterious statement asserted that Delta believes it can somehow succeed where Conoco Phillips has failed.

But the announcement was no prank. Shortly after the initial rumor hit the press, both Reuters and CNBC confirmed that Delta was, in fact, considering the acquisition. Financial analysts across the globe weren’t impressed; they reacted with skepticism, with criticism, and even with ridicule.

At first blush, of course, most of us would agree that it makes no sense for an airline to diversify into the oil business. But if we take a moment to reflect on Delta’s competitive position, we may start to understand why the airline believes the gambit may be worthwhile. The acquisition strategy, though unconventional in nature, is actually more reflective of the state of the commodity markets than of the state of the airline industry itself.

Method To The Madness

In order to understand Delta’s strategy, it is necessary to appreciate the impact that is wielded by fuel prices on the profitability of the airline industry. Generally speaking, the industry operates on very thin profit margins, with fuel alone representing almost one third of all operating expenses. Over the years, entire airlines have gone bankrupt because of aging fleets of airplanes that consume huge amounts of fuel, rendering flights unprofitable at virtually any level of passenger fares.

The challenge of high fuel prices is worsened by the impact of extreme price volatility. When American automobile drivers wince at double digit percentage increases in the retail prices of gasoline fuel, airline executives experience similar inflationary wallops and wince as well. In fact, such increases inflict far more damage on airlines than on automobile drivers, given that airlines must sign fuel purchase contracts well in advance, long before they know how many passengers will actually purchase tickets to board the scheduled flights.

If the fuel commodity markets were patronized exclusively by producers and users of gasoline, any such price swings would be determined by the economic market forces of supply and demand. But the commodity markets are also open to speculators who buy and sell huge quantities of the commodity, thereby causing wild swings in prices that can wreak havoc on the bottom lines of the low profit margin airlines.

So Delta has decided that it may be worthwhile to find a way to avoid the extreme volatility caused by speculator driven commodity markets. In essence, Delta is willing to bet that the cost burden of operating an unprofitable refinery — one that may nevertheless provide airplanes with fuel at prices equal to or below the cost of production — may be less onerous than the cost burden of purchasing energy from a wildly volatile global market. In other words, even though Delta’s strategy may appear to be madness, there is indeed a rational method to its underlying logic.

The $100 Million Man

Ironically, if Delta does proceed with the acquisition, the extent of its success will likely be determined by the conditions of the fuel markets that it intends to avoid. If those markets are relatively calm and rational, the airline will likely regret its assumption of the burdens of operating an oil refinery. But if those markets are relatively volatile and unpredictable, Delta will likely celebrate its decision to produce its own fuel.

In Delta’s defense, every week appears to produce a new story about the volatility of the global investment markets. Last week, for instance, a bizarre story about a “London Whale” spread throughout the financial press. The story involved a mysterious trader, working for JP Morgan, who was affecting market values around the world by investing heavily in derivative products called credit default swaps.

The trader, Bruno Iksil, reportedly earns $100 million per year by placing massive bets on the future movements of corporate bond prices. But because the placements of such large bets can themselves affect market prices, the very presence of traders like Mr. Iksil can affect what firms like Delta Airlines must pay to borrow money, to raise equity capital, and to purchase commodities for use in running their operations.

In other words, although our global debt, equity, and commodity markets were originally formed to help firms like Delta operate their businesses, they are now serving as vehicles for the highly speculative short term trading strategies of firms like JP Morgan. Apparently, Delta must now decide whether it would prefer to purchase fuel from a market that it doesn’t trust, or whether it would prefer to operate a refinery in a business it doesn’t understand.

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.

Health Care Consolidation: Efficiency or Monopoly?

Who (or what) should be blamed for the dramatic increase in the cost of private health insurance in the United States?

To a certain extent, of course, the aging of the population and the development of technologically complex treatment options have contributed to the burgeoning costs of insurance. Consolidation activities within certain sectors of the health care industry have impacted costs as well, with hospital mergers eliminating competition among providers and insurer mergers doing likewise among payers.

Last week, however, the city of Pittsburgh, Pennysylvania witnessed a health care consolidation transaction of a different kind. Instead of a large hospital or insurer swallowing up a rival, the insurance company Highmark decided to cross industry sectors and directly acquire West Penn Allegheny Health System and its Allegheny General Hospital subsidiary.

Why would Highmark want to do such a thing? And is the emergence of insurer / provider conglomerates a beneficial public policy development … or yet another nail in the coffin of a competitive health care system?

A Case of Vertical Integration

A producer purchase of a provider system isn’t a terribly unusual event from a macro-economic perspective. Energy production companies have owned or franchised retail consumer outlets for decades; Exxon Mobil and Chevron, for instance, simultaneously drill for oil, refine it into gasoline, and then develop franchise contracts with gasoline stations to provide it to consumers. Energy firms have even coined specialized terms to describe the dual sides of their business operations: the phrase upstream activities refers to the production process, whereas downstream activities refers to the refining, sales, and marketing processes.

Economists refer to this type of merger as vertical integration, a process by which a single firm acquires (or otherwise controls) an entire value chain of the production, sales, and distribution of a category of products or services. It is distinctly different than horizontal integration, a process by which firms merge with their competitors (or potential competitors) in order to develop larger market shares in their narrowly defined segments of their value chains.

In the private sector health insurance industry, employers generally purchase access to health care from insurance companies, which then contract with hospitals and other providers to deliver services to employees. Although patient advocates and provider lobbyists may argue that hospitals and patients occupy the very center of the health care system, from a value chain perspective, insurers can be characterized as upstream organizations and hospital networks as downstream organizations.

A Mixed Record

Clearly, vertical integration strategies have succeeded in the energy industry. But can they do so in the health care industry?

Based on recent history, the track record for such business strategies among insurers and providers is most decidedly mixed. On the one hand, Kaiser Permanente of California has remained one of the most highly respected and successful health care conglomerates in the nation by managing provider and insurer functions simultaneously. On the other hand, though, Humana — one of the largest health insurers in the United States — pulled out of the provider market in 1993 after concluding that there are too many natural conflicts of interest between the two industry segments to justify a conglomerate approach.

New York State, a geographic pillar of the national health care industry, has also experienced mixed results. On the one hand, the rise of the Catholic Church’s statewide health plan Fidelis Care did nothing to save St. Vincent’s Hospital of Manhattan, or its seven fellow Catholic hospitals in New York City, from closure. On the other hand, the New York City Health and Hospitals Corporation continues to find success with its wholly owned MetroPlus health plan subsidiary.

Efficiency vs. Competition

Interestingly, California and New York represent relatively competitive health care markets, with several hospital networks and insurance companies competing for business in each state’s major population centers. It is possible that the natural forces of free market capitalism have helped blunt the deadening anti-competitive effects of vertical integration in these regions, thereby preventing conglomerates from evolving into monopolies.

Pittsburgh, though, represents a very different type of health care market. Its hospital sector is currently dominated by the University of Pittsburgh Medical Center; thus, Highmark’s acquisition of the badly trailing second tier hospital may actually result in an increase of provider competition. Usually, merger partners argue that the beneficial cost efficiencies to be derived through consolidation justify the possible harmful effects of a loss of competitive players; in Highmark’s case, though, public policy advocates in the Steel City may enjoy the twin benefits of cost efficiencies and greater (as opposed to lesser) competition.

It is understandable why Highmark was attracted to the acquisition opportunity; after all, by strengthening the closest rival to a dominant hospital system, it may be able to improve its own contracting position with both medical providers. Although conventional wisdom stipulates that competitive markets often suffer whenever major organizations merge or acquire each other, from a public policy perspective, this particular merger might well produce a different outcome.

Google’s Gambit: Investing In The Wind

Politicians, environmentalists, and the private sector have been locked in debate for years over the future of America’s energy infrastructure. Should the largest economy in the world remain powered by oil, or should it switch to nuclear power? How about alternative energy sources, such as wind, water, and geothermal production processes? Or should America continue relying on oil as a primary resource, while simultaneously striving to develop domestic coal and natural gas supplies as well?

Of course, this choice of energy source and production method only represents the first challenge confronting America’s energy policy makers. They face a second challenge as well; namely, how should the energy itself be transmitted from the generation site to the user? Although the general public has always demanded cheap and readily accessible energy, it has no desire to live and work near gigantic towers of newly constructed power cables, fearing everything from property values declines to cancer epidemics.

An innovative solution, though, may have emerged last week from an unlikely source: the online search giant Google. With a single enormous investment decision, the firm may indeed have placed America firmly on the path to energy independence.

Harnessing The Power of The Wind

Most policy makers agree that renewable energy sources provide the most attractive long term potential for meeting America’s energy needs, considering their ubiquitous presence and lack of resultant environmental pollution. Ever since the Dutch first constructed wind mills to power their communal drainage systems and operate their milling factories, every breeze has carried the potential to power industrial societies, at least in the imaginations of romantic environmental visionaries.

Texas energy billionaire T. Boone Pickens has proposed the construction of gigantic wind mills throughout the wind swept Great Plains of the midwestern United States, but his plan has been stymied by the private ownership of prime locations, as well as community opposition to land-based transmission cables. And relatively small wind farms in the Atlantic Ocean, close to picturesque shorelines and islands such as Martha’s Vineyard, have been delayed by environmentalists and wealthy residents who prize their pristine ocean views.

What America needs is a series of wind farms that are as large as the land-based establishments proposed by Pickens, but that are placed far off-shore in the Atlantic Ocean to relieve the concerns of coastline residents. Such remote energy sources, though, would only be technologically feasible with an additional mammoth investment in the underwater sea cables that would be required to transmit the power to the mainland.

Enter Google!

This is where Google stepped into the debate last week, making a $5 billion investment in a proposed off-shore Atlantic Ocean transmission system that would span much of the eastern coastline of the United States, running from New York City to Virginia. Along with a matching $5 billion investment by the clean energy investment firm Good Energies, as well as a smaller stake by the Japanese trading firm Marubeni, the internet giant is placing a huge financial bet on the future direction of the American energy industry.

Why is Google so interested in America’s energy infrastructure? Its motivation should come as no surprise to any internet user; it must operate massive clusters of computer servers to provide its services to a web-surfing public, and those clusters require enormous amounts of energy for operational purposes. Nevertheless, although Google’s investment cannot be construed as a purely altruistic gesture, their decision may result in America’s long term gravitation from an oil-based economy to a wind-fueled one.

President Obama has long advocated that the United States government allocate significant research funds to the development of renewable energy resources. Many experts agree with the President about the wisdom of this strategy, noting (with some trepidation) the competitive investments now being made in China to capture the market for clean and environmentally friendly fuels. At a time when governmental resources are stretched thin, Google has decided to dedicate its significant private sector investment funds to a project that arguably supports the public interest.

Even Short Term Benefits

Interestingly, the project has been ingeniously designed to yield short term benefits as well. For instance, even before the off-shore wind farms are actually built and placed in operation, the transmission system will be able to carry power from the energy-rich southern states to the fuel-hungry northern regions. In other words, the system will be used to better match current supply and demand by utilizing a transmission capacity that is “out of sight and out of mind” to American citizens.

Will it ever be built? Will it successfully wean Americans away from their addiction to fossil fuels? Google itself has just placed a $5 billion bet on these questions, in the hopes that a successful investment will help our nation solve one of our most vexing challenges.