Market distortions favour fossil fuels

Fossil fuel subsidies cost governments 550 billion dollars annually according to the International Energy Agency (IEA), an independent, Paris-­based think tank. The International Monetary Fund (IMF) believes the cost of these subsidies is even higher, comprising 6.5 percent of global GDP.

Oil subsidies for consumers

Subsidies take on many forms. In Saudi Arabia, Nigeria and Venezuela – big oil ­producing countries – citizens pay prices below the cost-of-production at the petrol pump. Oil companies are paying to sell petrol in these markets. Why would they do this? International oil companies can still make a phenomenal profit exporting even just a fraction of their output and selling it at international oil prices. So they’ll agree to production contracts, in countries such as Iraq and Venezuela, where a significant proportion of output is nevertheless destined for the domestic market and sold below-cost.

State-owned oil companies, such as Saudi Aramco, do the same thing, but have a different motive. Saudi Aramco explicitly supports government policy aimed at reducing citizens’ cost-of-living. It can also easily afford to supply domestic markets with below-cost petrol by exporting the remainder.

Be aware that policies aimed at reducing the cost of petrol locally do little to encourage fuel efficiency. Furthermore, the IEA believes that only eight-percent of benefits from such subsidies flow to the poorest fifth of the world’s population.

More sagely, the Saudis also fund public projects, such as schools and infrastructure, with profits reaped from oil exports.

Oil subsidies for producers

Tax-­breaks encouraging the exploration and development of local oil reserves are another means of subsidising the oil sector – to the advantage of producers rather than consumers. In the United States, Exxon, Chevron, BP, Royal Dutch Shell and ConocoPhillips all claim tax breaks for exploration and drilling, known as “intangible drilling costs.” On average, seventy­-percent of these costs are regained within a year. [1]

Also, overseas royalty fees paid to foreign governments by US­-based oil firms can be reclaimed against their corporate income tax. Royalties are essentially the fees set by governments for foreign oil companies who wish to do business with them.

Exxon, Chevron, BP, Royal Dutch Shell and ConocoPhillips are all Fortune 500 companies and remain amongst the most profitable in the world despite the recent decline in international oil prices. Yet they’re not required to pay the full corporate tax rate as other for-­profit US companies do.

What’s more, “small,” independent US oil companies are also permitted tax breaks when the amount of oil extracted from an ageing production site starts to deplete -on top of the tax benefits described above. This is very generous given that tax is already proportionate to profit. Imagine that in 2003 my profit-take is $10 million USD. If the tax rate is 30% then I owe $3 million in taxes. If my profit-take drops to $9 million in 2004 my tax burden declines as well, down to $2.7 million. However, this additional tax-­break promises the bill drops even further. I might only owe $2 million. In this case my after-­tax profit is the same in 2003 and 2004: $7 million. Further, the majority of these “small” independents still have an average market capitalisation of two billion US dollars according to Oil Change International.

Oil companies contest that native exploration and production would not be profitable in the United States without these tax breaks. Yet, if a project is not economically viable why should the government of a market-­based society fund your commercial project? Well, there are circumstances under which this is considered appropriate. Perhaps your project serves the public good. This is why governments pay for fire stations, a police force or infrastructure like roads and electricity lines. Or maybe your project is part of the transition towards a greener and more sustainable economy? Or an attempt to curb greenhouse gas emissions?

Green subsidies for producers

Germany’s generous subsidies for renewable energies aspire to such ends. The country’s ambitious Energiewende policy, meaning energy “turn-around,” is the experiment the whole world is watching.

So far, these subsidies have had questionable success. Coal’s resurgence in Europe, along with the decommissioning of the country’s nuclear fleet, have increased Germany’s greenhouse gas emissions over the past few years.[2] Also, subsidies for renewable wind or solar farms’ installation and operating costs are passed on to the consumer. Average electricity prices in Germany have risen since 2008.

Furthermore, feed­-in tariffs that guarantee renewable energy producers a minimum price for their power, and priority to sell into the grid every day, are threatening the traditional market’s stability. Unprofitable gas and coal power plants’ operating hours are decreasing and many have had to close. This could lead to supply shortages and brown-outs or black-outs in the near future.

Finally, it has been demonstrated that early subsidies for solar panels stunted the innovation that would’ve brought commercially viable solar technologies to Europe’s markets sooner. The same technology lag effect has been observed in offshore wind.

Nevertheless, if energy subsidies exist at all surely they should favour low or zero­-carbon energies? It makes no sense for governments the world over to subsidise – to the tune of billions of dollars – the energies increasing the concentration of greenhouse gases in the atmosphere to the disadvantage of other energy sources. Current subsides for renewables comprise but a fourth of what goes to fossil fuels annually. If renewables were to receive the subsidies that fossil fuels do then the market would favour carbon­-friendly energy production over fossil fuels. It is worth making renewable energy production more profitable than it would be otherwise given the global threat of climate change. The same cannot be said for fossil fuels.


[1] References: The Atlanticthe IEA & the IMF.

[2]  This applies primarily to the electricity sector, but overall emissions did rise between 2009 and 2014. The 2008 drop is attributable to the Global Financial Crisis and economic downturn across Europe. Hopefully 2015 is the year this trend will turn-around. Take a look at this graph.

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Climate vs. Weather

Climate change is underway. The mainstream now accepts that human behaviour and industrialisation contributed to increasing the amount of greenhouse gases present in the atmosphere over the last century. Yet, it remains difficult to link specific weather events to climate change.

Climate is not the same as the weather. Weather is a local phenomenon. Also, it is very predictable despite what you might think about your local weather channel. Forecast accuracy increases significantly one week out, one day out, one hour out, as we approach hour zero. Even ten-year olds learn that when winds gather in the harbour and clouds are swept inland, rain will begin to fall as the clouds cool rising above sea level.

Climate is the aggregate of weather patterns on a regional or global scale, averaged out over years, decades or even centuries. Climate systems are “chaotic”. In scientific terms this means highly complex with numerous interdependencies, so it’s very difficult to make predictions.

Scientific models are getting better all the time, but the climate’s “chaotic” nature means even tiny deviations in initial data and assumptions, can lead to wildly divergent results. John Nash’s poetic metaphor, referred to as the butterfly effect, translates this concept into everyday language: when a butterfly flaps its wings, a hurricane is born on the opposite side of the globe. Climate scientists have millions of butterflies to consider.

Furthermore, changes in the aggregate tell us little about the local effects of climate change. Weather scientists can tell us what the weather will be like in London, Dubai or Delhi tomorrow. But climate scientists do not have the same job. They cannot paint a very accurate of picture of what daily weather will be like in Delhi in ten or twenty years time. Will Californian residents suffer fewer droughts if America bans emissions-intensive coal power production? What colour is the butterfly’s wings?

This is where statistics can play an important role. Statistic climate models measure how likely it is that something will happen. Lord Stern’s landmark 2006 report for the British government (research that was updated in a 2014 report with the Global Commission and the Economy and Climate) evaluates the risks and probabilities associated with climate change – from both a business and government policy perspective – despite scientific uncertainty.

We know that extreme weather events have become increasingly probable. We will witness both more frequent and more intense storms, heat waves, polar vortices, droughts and fires. Landscapes are changing as coastline disappears. Higher average temperatures affect ecosystems. The indirect costs of climate change include crop failure, mass migration, loss of biodiversity and a spread in airborne maladies. Dangerous air pollution in many cities worldwide, caused by burning fossil fuels, furnishes us with yet another reason to quit pumping the gases they produce into the atmosphere.

We also know that certain regions face greater risks than others. As fate would have it the regions most susceptible to climate change’s impacts are those least equipped to deal with them. Such as the Pacific islands and South-East Asia.

Why is that? A priori,  proximity to the ocean and the equator entails more extreme weather, which climate change will exacerbate. Yet, these regions are also less developed. They are incredibly dependent on the weather to ensure reliable food production. Insurance policies are rare. Millions of people live in very simple shelters, easily destroyed in high winds or fires. Their communities often lack modern luxuries such as electricity, televisions, insulation, climate control or running water. This means they are more likely to die during or following an extreme weather event – because they do not receive the evacuation message, cannot adequately shelter themselves or escape the heat or cold, and may starve or be forced to drink contaminated water whilst awaiting disaster relief.

Hurricanes are common in the South Pacific region between November and April. However, earlier this year, Vanuatu was battered by extrordinarily violent winds and rain for which there was little precedent. The initial deaths following Cyclone Pam were tragic. However, starvation and water contamination followed and pushed the death toll up. Economic reconstruction of the region, which is primarily dependent on subsistence farming, will take years.

Another recent example: thousands perished in a dangerous heat wave throughout Pakistan and India’s north where temperatures reached 47 degrees Celsius in May of this year. We cannot overestimate the danger of excessive heat for infants and the elderly. People’s bodies become very stressed under such conditions. This combined with dehydration or sleep deprivation leads to fatalities.

Sceptics are right to doubt that Cyclone Pam or the recent heat wave were directly caused by climate change. Drawing a direct vector between burning fossil fuels and extreme weather events is near impossible as explained above.

Nevertheless, these regions have not benefitted from industrialisation, and the tremendous boost to economic well-being it engendered, to the extent that we have across the developed world. Yet, they will be the first to suffer from industrialisation’s perilous side effects.[1]

This is why Cyclone Pam and the Pakistani/Indian heatwave are relevant. These examples help us to identify what is really important about climate change. Climate change is a question of social justice, not the weather.


[1] Not that pockets of wealth do not exist in these regions or people in more developed parts of the world have never known disaster – as witnessed in 2005, in the United States  following Hurricane Katrina.

Future electricity grids: the rise of the prosumer

Unlike other commodities such as gas and oil, electricity cannot  be easily stored. It must be consumed almost as soon as it is produced.

Consumer demand follows a fairly predictable pattern. Electricity prices are higher on weekdays when “peaking” power plants come online to satisfy increased demand. The first demand peak occurs in the morning – when a high proportion of the population is getting ready for work or school.  A second peak occurs in the evening when consumers return home and start cooking dinner, or turn on the television.

Conventional power generators such as coal and gas turbines can respond quickly to variable consumer demand by increasing fuel input and ramping up output during the day. Nighttime is a cool-off period.

Intermittent renewables changed this model. We must now factor in unpredictable supply peaks and increased price volatility. In the UK and Germany consumers bear the brunt of these new costs. You can read more about how renewables are shaking up the traditional power model here. 

There are several ways to manage this new supply intermittency and smooth prices.

One is more interconnections. These reduce bottlenecks and diversify supply sources so that electricity-rich areas can service electricity-poor ones. Nations hoping to boost electricity production from renewable sources will need a well-connected grid, as an oversupplied area can experience shortages as soon as the weather changes. New power lines require public support and investment.

Short-term (spot) electricity trading can optimise electricity flows between areas and facilitate price arbitrage. Spot trading services are offered by EPEX Spot in Central Western Europe or ERCOT in Texas, for example. These services also permit renewable energy producers to rebalance their books if the weather forecast was inaccurate and they produce much more or much less electricity than predicted.

Smart grid technology uses real-time information about supply and demand to automatically adjust electricity flows curtailing price peaks (or negative prices). Again public money is needed to roll-out this infrastructure at the national level.

Another means is electricity storage.

Pumped hydro-storage has existed for a long time. It is the only large-scale storage technology used commercially. It involves pumping water uphill when electricity prices are low, then running water downhill, through turbines, during peak-price hours to generate electricity. Pumped hydro projects are nevertheless hugely dependent on local geography and rainfall, as well as regulations regarding water-use.

The lithium-ion batteries used in electric cars pack a lot of energy density for their size. They cost around US$10 000, even for a small vehicle, and can only run for about 175km before recharging. This could be better. Crucially, lithium-ion batteries do not suffer from “memory” issues. Meaning that don’t need to be drained before being recharged.

Battery manufacturers across Asia and the USA are struggling to cut costs and upscale their technology to plug into the electricity grid. Yet, electricity generation is decentralising. Small-scale industrial and household solar production is on the rise. Rather than selling their excess power back to the grid some could go off-grid.

Most experimental batteries would need to be bigger than a house in order to store enough solar electricity to power one household for a day. And they remain prohibitively expensive. However, Tesla caused a lot of excitement last month when it announced plans to market lithium-ion batteries at prices starting from US$3500. It costs a household a further US$5000 or so to install solar panels. Nevertheless, this much-anticipated battery is priced lower than any other technology on the market. The Tesla battery should be small enough and safe enough to install in your basement. Plus, you don’t need to be a rocket scientist to operate it.

How did they do it? It’s not new technology. Rather, Tesla is building a US$5 billion gigafactory in Nevada’s desert, where it hopes to realise enormous economies of scale. While the market is still waiting for a technological revolution – the step-change that would make batteries as portable and powerful as microchips which are continuously delivering ever cheaper computing power – Tesla intends to reduce manufacturing costs for current battery technologies.

There is a sizable market of homeowners prepared to fit out their homes with solar panels, battery storage and adopt other energy efficient technologies. These early adopters need enough cash to  invest upfront, before they reap the benefits in reduced or zero-cost electricity bills in the months and years that follow.

For most middle class homeowners US$8500 is no small fee. Companies such as SolarCity in the US provide another piece of the jigsaw. Financed by high net worth individuals, as well as Google and Goldman Sachs, the company pays for solar panel installations, aggregates the earnings from energy savings and grid buybacks, then sells bonds based on a predicted revenue stream. Such creative financing will hasten the prosumer revolution and eventually take some of us off-grid.

No one technology will solve all the problems intermittent renewable energies have introduced into electricity markets. A patchwork of different solutions looks likely to emerge – with some consumers taking matters into their own hands.

Low-hanging fruit

Energy efficiency wants more energy for the same amount of fuel. This means both energy bills and pollution from burning fossil fuels fall – to the delight of government and environmental agencies alike.

There are three key sectors within which efficiency gains can have a significant impact in both the developed and developing world: transportation, buildings and electricity.

Simply replacing old cars and trucks with newer versions reduces overall oil usage per vehicle. New vehicles are built to higher fuel efficiency standards as the technology continues to improve, so that you can drive your car further and further using less and less petrol. Manufacturers were busily engineering new models whose improved fuel use and decreased gasoline bills made them attractive to consumers, even before regulation insisted on higher fuel efficiency. Inefficient and dirty, (but cheap) diesel is now highly regulated in the developed world. It is all but obsolete for passenger vehicles. Low-quality fuels for marine transportation and long-distance trucking have yet to be attacked with the same rigour.

It’s also about not wasting energy. Inefficient buildings release huge amounts of unused heat.  Simple measures include nailing shut the last few millimetres between insulation boards – this final step brings the greatest benefits – or using straight, fat water pipes rather than slim, angular ones. These are not universally understood or implemented.

Insulation, heat pumps and newer appliances compliant with current efficiency standards make a huge difference. The invention of light emitting diodes (LED) revolutionised lighting. Previously incandescent light bulbs lost most of their power as heat. Solar and geothermal installations can make buildings energy neutral or turn them into prosumers.

Although this involve additional costs, many energy savings measures pay for themselves within a few years, as heat and electricity bills are cut.

Retrofitting older buildings and replacing appliances is necessary to address standing building stock. Unlike cars, buildings are not replaced every few years. Most of today’s buildings will still be standing in fifty years – but we suffer from an agency problem. Landlords do not pay the energy bills and tenants do not wish to invest in someone else’s property. Yet, even property-owning households and businesses hesitate to retrofit. This is where government incentives can play a role. Heating, cooling and electrifying buildings makes up a third of global energy consumption, so lifting efficiency by just a few percentage points gets purchase and demonstrates the worth of such efforts.

Efficiency was transforming electricity production until renewables shook up the model making even the most flexible and efficient Combined Cycle Gas Turbine (CCGT) plants, which save and reuse heat produced during power production, unprofitable. Nevertheless efficiency can still give thermal power producers an edge on the competition, since decreased fuel use cuts operating costs. Further, governments are imposing tariffs on heavy polluters including inefficient diesel and coal-fired relics. This additional marginal cost crowds some of them out of the marketplace saving energy and reducing pollution.

Demand-side management can address some of the short-fallings of today’s decentralised electricity system. With smart metering industrial and household consumers can react when electricity is scarce (wind or solar production is low). The higher prices signal factories to run less energy-intensive processes or wait for off-peak prices and hours, and household consumers can decide to take a shower or do their washing later on. In fact  smart grids can even automate some of these decisions, at both the local and national level.

Once upon a time, rising energy consumption was an accurate indicator of how fast an economy was growing. No longer. In the OECD, efficient technologies and smarter policies have decoupled energy consumption and development, proving that environmental concerns need not frustrate economic ones.


Sources:

Invisible Fuel, The Economist

Energy Efficiency topic, International Energy Agency, OECD

Renewables menace traditional power model

Lots of things are shaking up the traditional power model. A decade ago gas and coal power plants were very profitable. Retail companies, which distribute to industrial and household consumers, bought wholesale electricity at a price that always covered operating costs and got a healthy boost during peak demand hours. Even fairly inefficient power plants could expect to have enough profitable operating hours to keep in the money.

Electricity generated from renewable energy sources has altered this dynamic, most noticeably in Germany where Energiewende policies encourage renewable energy development. The upfront costs of new renewable energy projects are subsidised. Once operational wind or solar parks are given priority access to the distribution grid – they can always market the electricity they produce. Furthermore, the government pays out a “feed-in” tariff. That is, guarantees a certain price for every megawatt hour of electricity generated by a wind or solar farm.

These policies have discouraged private investment that might have brought more competitive renewable energy technologies, ones that do not require government subsidies, to market sooner. Nevertheless, Germany’s goal to get 60% of its electricity from renewable sources by 2050 is on track. The eventual success or failure of these policies is the experiment the entire world is watching.

However, the rapid expansion of renewables has upset the incumbents – traditional thermal power generators that use coal and gas as fuel. Renewables harm their profitability for a number of reasons.

First of all, the average wholesale electricity price is lower. Once a wind turbine or solar panel is installed operating costs are near zero because the wind and sun are both free fuel sources. The price of electricity depends on where inflexible consumer demand matches producers’ supply. The producers with the lowest operating costs are always called on first. Then the price of electricity creeps up the supply curve until consumer demand is satisfied. Every day, every hour, producers receive a price for the electricity they produce based on the last generator called up in the so-called “merit-order.” The graph below illustrates this.

meritorder

The last generator is always less efficient. This means that its operating costs are higher and it will only generate electricity when the price covers these operational costs. Now that renewables are part of the merit order, we don’t climb as high up the curve as before. On average, prices have decreased, implying the recurrent “last generator” is more efficient than a few years ago.

Second, thermal power plants’ operating hours are down. A lot of electricity is being generated from renewable sources replacing supply previously provided by gas and coal power plants. This point is obvious – money can only be earned when your power plant is online and generating electricity. This adds to traditional power plants’ woes. Prices are weakened, but their sale volumes are also harmed as renewable energy production grows.

Third, renewables are very variable. Already gas power plants have shut down and new projects have been cancelled because they could not survive the renewables’ economic shake-up. However, some days the sun does not shine, or there is no wind, and traditional generators are still needed. This can vary hour-by-hour, minute-by-minute. Only very modern gas facilities are capable of ramping up and down to balance unpredictable renewable production. Although, this is simply not profitable in a weak price climate where operating hours are down. So, these rapid-response power plants are no longer being built. This is called the “missing money” problem.

Fourth: the rise of the prosumer. Households and businesses have been installing solar panels with the hope of decreasing their electricity bills. In some countries, excess electricity that is generated can be injected into the grid earning you cash back from the local electricity retailer. This is how the word prosumer came about. Households connected to the distribution grid were traditionally pure consumers. Having installed solar panels the consumer is now a producer as well. They may even be electricity self-sufficient on sunny days or exceed their own electricity needs, affording them the opportunity to sell back to the grid.

Alone, one solar powered household cannot produce enough electricity to perturb the traditional power model. Yet, the arrival of hundreds and thousands of prosumers on the grid has the potential to be very destabilising as seen with commercial solar generation.

These four issues are part of a bigger problem: electricity infrastructure and markets are inflexible. They were not designed to manage decentralised and unpredictable electricity production. Nevertheless, this is the model we will have to manage in the future. Distribution lines also have ramping limits constraining how quickly power flows can be increased or decreased. Volatile prosumers and commercial wind and solar farms compromise the grid’s technical stability. And we still need back-up for the days and hours when renewable electricity production is low. Managing variable electricity production demands a model where this responsibility is shared by the market players.


Graph was found at www.powermarket.eu

Electricity prices & the solar eclipse

Electricity cannot be stored. When the sun hits a solar panel, or coal is burnt to turn a turbine and generate an electrical current, this energy is delivered to the distribution grid straight away.

Spot markets are where wholesale electricity producers and consumers go to balance their planned against their actual electricity needs. Those needs become clearer the closer we are to delivery, which is why electricity is often traded the day-ahead, or on the same day as delivery to the grid (intraday). This is particularly true for solar and wind power generators since the weather forecast becomes increasingly accurate from 24 hours out.

Solar eclipse

If you are a solar power farm what do you do if your energy source – the sun – goes offline? This is what happened last Friday morning, March 20th, in North-Western Europe. A solar eclipse, lasting around 75 minutes, during which the moon at least partially blocked the sun, had a big effect on solar electricity production.

Germany was particularly affected. Today it gets approximately seven-percent of its electricity from solar energy.

The celestial event affected French-German intraday spot prices between 9:00 and 11:00am. If you didn’t know better you might’ve thought the traders had pressed the wrong buttons on their keyboards! Bids as low as -975.00 euros and as high as 950.00 euros were tendered. To give you an idea prices are normally closer to 20.00 or 40.00 euros on the intraday market at the moment.

The final prices did eventually settle at 40.79 euros for 9:00-10:00am, and 66.37 euros for 10:00-11:00am, but varied a lot within the hour. Some 15min intervals settled at a negative price. This is not so unusual and has been seen before.[i] Nevertheless, the spot market demonstrated strong resilience to price volatility during the eclipse.

Negative electricity prices

When wind and solar generators have really good days electricity prices can drop below zero.[ii] The negative price means the market is oversupplied.  Everyone produced more electricity than expected and they don’t know what to do with it.

A negative price indicates you would actually pay someone else to use the excess electricity you produced. Why? It might be too late to decrease your production. Gas, coal and nuclear power plants need several hours to warm up (or down). Such facilities do not have simply on/off switches.

Avoiding blackouts

Those in charge of maintaining electrical grid stability, Grid Operators, can impose large fines if you exceed what you committed to delivering to the grid. Or if you do not produce as much as promised. Paying someone else to consume your excess electricity is probably a lesser loss than the fines imposed by Grid Operators.

The Grid Operators impose these rules because electrical currents need to be gently “ramped up” and “ramped down.”[iii] They have to plan ahead to ensure electricity flows safely and avoid blackouts.

What’s more consumers are fickle. You wouldn’t have been happy if your computer crashed, or you couldn’t make a cup of tea during your morning break because there wasn’t enough electricity – solar eclipse or not.

No one knew exactly how the solar eclipse would affect production, which explains traders’ erratic behavior. Somewhere else in Europe a more flexible electricity generator – probably a gas-fired power plant – had to quickly ramp up production to replace the eclipsed solar generation and meet consumer demand. Only the most modern and efficient power plants can react this quickly.

A test for Germany

The sudden drop in solar electricity production was an important test of grid stability. If Germany achieves its 2050 goal to produce 60% of its electricity from renewables, then cloudy days will have an affect on the grid as significant as last week’s solar eclipse.

The European Union also plans to increase the share of renewables in electricity production across the continent. In the future enormous swings in solar production could become commonplace.


[i] Take a look at all the prices here.

[ii] Sunny days tend to be windier then average, so solar and wind production peaks can coincide.

[iii] Imagine pulling your hairdryer out of the wall when it’s on full blast. Sparks fly! Multiply that effect by thousands and you can imagine the challenge for Grid Operators.

Oil trading 101

For those of us who never studied finance or economics, terms such as hedging, futures and long position are very mysterious.  Let’s look at a basic oil trading strategy: selling the futures spread, to understand some of these terms.[i]

First of all, what is a futures contract?

If I sell a contract, to deliver 1000 barrels of oil in December 2015, I have  sold an oil futures contract.

For example, I promise to supply a customer, let’s call him Harry Potter, with 1000 barrels of oil in December. Harry pays this December price to secure his supply and I lock in a comfortable price. Why would Harry do that? If the December futures price is currently $50 Harry probably believes that, come December, the real oil price will have changed. If it turns out to really be $70 (multiplied by 1000 barrels!) then Harry has won. He paid his supplier – me – much less then he would have paid if he had waited until December.

$70 – the actual price of oil in December – is called the December “spot” price.

On the other hand, if it turns out the December spot price falls to $45 then the supplier made the better deal. I wait until December to buy 1000 barrels of oil at $45 each. I supply these barrels to grumpy Harry who already paid me $5 more per barrel and rather thought he had made a good deal back in March.

Oil future prices emerge because different players have different expectations about how oil prices will evolve.

Current market conditions

The oil futures market  is currently in deep contango. What does this mean? Contango means traders expect the price of a barrel of oil to be higher in the future than it is today. Deep contango means this price will be a lot higher. Yet, as we just saw above, when delivery day arrives the spot market might tell another story.

As a trader I need to make a prediction about what will happen over the next few months

For example:

  • Oil storage facilities are near capacity in Europe and essentially full in the US. Storage is becoming inaccessible.
  • Today’s spot prices are at a historic low. I might think they are likely to drop further, since producers cannot store oil to sell later and will be forced to dump their supplies somewhere.
  • Many producers are becoming unprofitable. Investment in new oil production projects is being put on hold because prices around $40-$50/barrel are not enough to cover production costs.
  • If there are few new projects to replace current production then oil supplies will eventually tighten and prices will increase. But not for at least a year or two. Identifying this lag is crucial.

This means the contango will deepen.

Based on the above predictions, I would expect the futures spread to widen. That is, the difference between the spot and future price of oil will get much bigger.[ii] Why?

To reiterate: spot prices will decrease as we have a situation of oversupply that is likely worsen when oil storage facilities run out. Then the oil futures price will increase, relative to spot, since the market is not expected to tighten for one or two years. This pattern should hold for some months.

My trading strategy, based on these expectations, is to sell the futures spread.[iii]

Selling the futures spread means I sell a futures contract for a near month  and buy a futures contract a far month. This will be profitable if I am right about the contango spread increasing.

For example:

It is March 2015.

SELL TIME SPREAD:

  • Sell April oil futures contract @ $48.13
  • Buy May oil futures contract @ $49.13
  • The spread is -$1 per contract.

It is now April 2015 and I need to offset my position.

BUY TIME SPREAD:

  • Buy April WTI spot contract @ $47.13
  • Sell May WTI futures contract @ $51.13
  • The spread is now -$4 per contract.

Intuitively -4.00 < -1.00

So I sold something at a higher price than I bought it back for. Profit!

My total profit is: (-1) – (-4) = $3 x 1000 contracts = $3000

A helpful guideline:

Which trading strategy to use?   Contango time spread (normal market) Backwardated time spread  (inverted market)
Expect the spread to widen Sell spread Buy spread
Expect the spread to narrow Buy spread Sell spread

Selling the spread:  short the near futures position and long the far futures position.

Buying the spread: long the near futures position and short the far futures position.


[i] Please be aware that this example is pure fiction and the author takes no responsibility for losses or gains made by anyone trading oil futures based on the above-described strategy.

[ii] It does not really matter what the price level is per se. So it’s not helpful to say “prices will go up.” Relative to what?

[iii] Short = sell, long = buy. These terms do not have anything to do with time-frames!

Canada’s tar sands: unburnable carbon

Canada’s tar sands contain some of the biggest proven oil reserves in the world. They are mainly found in Alberta. But mining these tar sands, to produce ‘synthetic’ crude oil, is expensive. The process also releases more greenhouse gases than conventional oil production does. If we are serious about arresting climate change then these reserves need to stay in the ground.

What are tar sands?

Tar or oil sands are unconventional natural crude oil sources that have a viscous, tar-like consistency. A mixture of sand, clay, water and bitumen, the sands are really a bio-degraded form of crude oil: “Old oil, [it’s] kind of like old wine that’s past its peak.”[i]

The bitumen part must be separated out and then upgraded into a synthetic crude oil (syncrude) before it can be further refined into petroleum products like gasoline and diesel.

Two different production processes can be used to extract the bitumen from tar sands: open-pit mining, used when oil-sands deposits are close to the surface; and in-situ mining, used when oil deposits are deeper underground.

Open-pit mining accounts for around half of all production. The process is destructive. First, forests must be cleared away. Then the tar sands are dug out, using enormous shovels, and they are then transported to processing facilities in trucks several storeys high.

Greenhouse gas emissions

‘Well-to-wheels’ life-cycle methodologies calculate the GHG emissions released in producing a petroleum product and getting it to the petrol pump. They don’t calculate emissions once you start driving. According to IHS CERA an Albertan tar-sands project releases between five and 15 per cent more GHG emissions from ‘well-to-wheels’ than does conventional oil production.

The extra emissions come from two main sources: fuel input and ‘fugitive’ emissions. Fuels used in open mining projects include diesel, electricity and natural gas – for trucking and steam production, and for upgrading the oil to create syncrude. (Syncrude then has to be refined again to obtain the final-use fuel.) Around 20 per cent of all Canadian natural gas produced serves the tar-sands industry.

Fugitive emissions are another problem. They stem from natural gas leakage, venting or flaring during mining. Venting is a process that releases any associated natural gas into the atmosphere; flaring burns off this unwanted by-product – because it’s not profitable to get it to a pipeline. 

Overall, the Canadian oil-sands industry generates emissions equivalent to Portugal’s – as a country. Portugal is ranked 56 out of 142 GHG-emitting countries worldwide.[ii] Open-pit mining also has the added effect of destroying Albertan boreal forest – a net carbon sink. All this makes Canadian tar sands development a significant net contributor to global climate change.

Who is the consumer?

Despite the emissions released during production, final-fuel combustion is ultimately more troubling. Emissions weigh heavily in the consumption phase, contributing 70 to 80 per cent of overall lifecycle emissions.

The US is Canada’s primary export market for syncrude. It is transported by pipeline to specialised refineries mostly in America’s Midwest. Around three-quarters then becomes gasoline and a quarter is turned into diesel, feeding domestic markets.

The controversy surrounding the Canadian-US Keystone XL pipeline project stems from US environmentalists’ opposition to production from the tar sands, since it is a particularly emissions-intensive source of crude oil. Yet, Albertan syncrude can still be imported by train, with or without Keystone XL, and transport by train has historically caused more leaks and accidents

Unburnable carbon

If all known oil reserves worldwide were extracted, produced and then used, climate change would occur on a dramatic, irreversible and dangerous scale. We have a lot of ‘unburnable carbon’. So we need to choose which sources, if any, we are going to develop. ‘Unburnable carbon’ refers to fossil fuels that can’t be burnt if the world it to limit carbon emissions so as not to trigger serious climate change.

Most oil that is easily and commercially producible around the world therefore needs to remain in the ground.

Tar-sands projects are among the world’s most expensive and marginal oil production projects – meaning that the cost of production is significantly higher than for conventional oil. In addition, tar-sands oil is only profitable when international oil prices are close to $100 per barrel. Canadian producers are already taking a hit. The International Energy Agency has estimated that a new Canadian oil sands project will cost up to 10 times that of a conventional project in the Middle East.

The economic cost

Research by the Canadian government and the Pembina Institute shows that Canada’s manufacturing slowdown is partly the result of the Canadian dollar appreciating. This has risen over the past decade as exports, mostly of crude oil, have risen. Essentially, the development of Alberta’s oil sands is hampering the manufacturing growth.

Continued reliance on commodity exports will divert investment away from the transition to a low-carbon economy. Being endowed with diverse natural resources, and having advanced manufacturing, service and innovation sectors, Canada has alternatives. Progress within more innovative and value-additive sectors is being overlooked, locking Canada into a high carbon-intensity development path.

The impact of tar-sands development on global climate change, though alarming, is not the only reason to discourage such development. They are not only of questionable benefit to the Canadian economy overall but are unlikely to remain profitable in a low oil-price climate.

Finally, as a significant GHG emitter, if Canadian politicians were to take a lead on climate change issues they could have a real political impact worldwide. Perhaps, the Canadian government and people could leave these particular hydrocarbons in the ground.


[i] The U.S Oil and Gas Boom, Ifri 2012

[ii] S. Dyer, M. Dow, J. Grant, M. Huot & N. Lemphers, Beneath the Surface : a review of the key facts in the oil sands debate, The Pembina Institute, 2013

Note: where unquoted statistics can be credited to the Pembina Institute.

What the frack?

The US shale revolution is a hot topic these days. It’s one reason  America recovered faster than Europe following the 2008 global financial crisis. But what is shale gas and shale oil? And what’s all the controversy about?

Fracking 101

Hydraulic fracturing, abbreviated to “fracking,” technology is not new. It’s been around since at least the 1920s. It simply got cheaper and easier to do in the last ten years. Basically, instead of drilling multiple wells to extract gas or oil from underground rock formations, water or a mix of chemical lubricants is injected into the ground at very high pressure to shatter or “frack” the surrounding rock and increase yield from the well. This can be done several times at different intervals along the well shaft. The gas then travels up the well shaft and is collected at the surface.

Fracking can also be carried out horizontally as sketched in the diagram below. Rather than drilling several vertical wells down into the same shale rock layer, the well turns a corner and follows the hydrocarbon producing rock.

fracking-diagram

Shale gas is the same organic compound we refer to when we say natural gas – primarily methane. Shale actually refers to the porous rock within which gas is trapped. Generally shale, but sometimes sandstone. It’s like a solid sponge which shatters under the high-pressure injections of water and releases gas.

The most profitable shale “plays” (industry-speak for a geological area containing underground shale gas reserves) are described as “wet” because they also contain crude oil. This liquid hydrocarbon is called shale oil or light, tight oil being trapped in the porous rock and very high quality crude.  [i]

The shale gas revolution

Small and medium-sized producers began fracking in the United States several years ago. Enormous shale plays were discovered in Pennsylvania (Marcellus), Texas (Eagle Ford), and North Dakota, Montana (Bakken). All very profitable whilst international oil prices were high. Since the US gas pipeline network is so well developed it was easy to market the associated natural gas.

The gas market was flooded with diverse new supplies – decreasing gas prices at physical trading hubs substantially. This was a huge boon for industry. Cheaper energy has made US exporters more competitive whilst Europe continues to struggle with higher gas prices and economic recession.

It was heralded as a golden age of gas. This was good news for US greenhouse gas emissions too. Emissions have decreased since gas became more competitive with cheap, but polluting coal in the electricity sector. Additionally, some fuel-switching has occurred with natural gas replacing petrol in a limited number of cases in the transportation sector. This is no small achievement. The US transportation sector is overwhelmingly the greatest source of greenhouse gas emissions in the world.

Could the shale gas revolution happen in Europe?

Two factors allowed US production to take off the way it did. Firstly, in the United States mineral wealth is privately owned. Meaning whatever you dig up and find in the subsoil beneath your property belongs to you. This is why we have the stereotype of a Texan oil baron. A lucky farmer that strikes oil on his ranch keeps one hundred percent of the profits. (Best practice is to hide your find from your neighbours for as long as possible, lest they get digging as well).

In Europe governments retain mineral and mining rights. There is much less incentive for small-time producers to drill for hydrocarbons outside of the United States. Despite your capital investment, the profitability of the project is unpredictable.

Second, the industry was almost completely unregulated when it got started. The wells were already pumping gas and turning a profit before proper regulatory oversight came into play.

Fracking companies have been targeted with accusations of poisoning aquifers. Aquifers are a subsoil layer that must be drilled through to reach shale rock formations below. This is also referred to as groundwater – frequently a natural source of water for rural and urban communities.

There have been cases of the chemicals used during fracking processes leaking into the groundwater in parts of America. Very toxic lubricants were used to make the wells more productive in the early days. Nowadays shale gas producers are willingly reporting the chemicals they are using, (previously considered a commercial secret,) to try and regain the American public’s confidence. And a properly reinforced well should not be leaking into an aquifer for any reason. It’s eventually been made harder for frackers to get the right permits to go ahead with new projects.

Proper geological imaging to ensure wells are drilled far from sensitive fault lines, as small earth tremors have been linked to fracking processes, and regulations regarding water use in drought-prone areas have emerged too.

There are shale basins in Europe, notably in France, Poland and the UK, quite close to dense population centres. If proper regulation oversees the production process chemical leakage and earth tremors are totally avoidable. Nevertheless, the conditions that shaped a shale gas revolution in America are still unlikely materialise in Europe.


[i] This should not be confused with oil shale, which is kerogen. Kerogen rock needs to be heated up to extract crude oil. This is a very different and more expensive industrial process.

Oil prices not too low for Saudi Arabia

My last post explained why international oil prices have fallen dramatically during the last six months. This has harmed the profitability of many oil producers.

International oil traders and producing companies have called on the Organisation of Petroleum Exporting Countries (OPEC) to react to the fall in oil prices. Saudi Arabia is the biggest producing country within OPEC and often represents the group. But what can the Saudis do?

For a long time Saudi Arabia was the world’s largest oil producer. The shale oil revolution changed this. Last year, we saw the US overtake both Saudi Arabia and Russia – the other big player – to become the world’s largest oil producer. Nevertheless, the US consumes a lot of what it produces. Saudi Arabia is still the world’s biggest exporter. Moreover, its vast reserves and production capacity allow it to “swing” supplies. That is, quickly alter the volume of oil it puts into the international market. In a nutshell, decreasing copious OPEC supplies would alleviate the international supply-glut and boost the international oil price.

To do this OPEC must accept a decrease in total sales volumes and a smaller market share. The burden of cutting back volumes falls predominantly on Saudi Arabia as OPEC’s biggest producer. Saudi Arabia has had experience in the past with cutting supplies whilst other OPEC members “free ride.” Meaning they benefit from an increase in prices without decreasing their sales volumes as agreed.[1]

International producers are effectively asking Saudi Arabia to do them the same favour. Just why would it do so in a competitive market?

For the moment Saudi Arabia has indeed refused to offer anyone any favours. What’s more getting oil out of the ground is very cheap in Saudi Arabia. Its oil wells have some of the lowest “lifting” or production costs in the world. This is what the graph below shows us:

BEP - IEA graph

The ultra-polluting Canadian tar sands projects are well out-of-the-money at oil prices of $50/barrel, since it costs $85 to produce a barrel of oil.[2]

The graph also shows us that Saudi Arabia can remain profitable close to $20/barrel. It could let current prices keep falling without sacrificing market share. Today’s oil price is less of a problem for Saudi Arabia than other countries where lifting costs are higher.

Yet, it is unlikely Saudi Arabia will let prices fall that far. Profits from oil sales directly support the Saudi government’s budget. Also, higher prices eventually become more important than sales volumes as profit margins tighten. For example, if I sell ten barrels at $100 each this is the same as selling a hundred at $10 each. Except that if it cost me $9 to produce each barrel my total profit is $910 in the first scenario and only $100 in the second scenario.

For now Saudi Arabia appears content to keep the price low and wait for US shale oil producers with thinning profit margins to leave the market. This strategy will cause the US shale oil revolution to lose pace and protect Saudi Arabia’s market share in the long term. However, we might see OPEC revise their policy later in 2015.


[1] It’s hard to measure exact output and countries report their own production volumes.

[2] I’ll write about the economic feasibility of the tar sands projects soon.