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The Economics of Energy
By Bill Snyder
START IN SANTA BARBARA, CALIF., and drive north along the twisty coastal highway to San Luis Obispo. Turn right and head east to the hot, grassy Carrizo Plain an hour or so away. In the span of an afternoon's drive you'd see three very different visions of the world's energy future: off-shore drilling rigs, a massive nuclear power plant, and the site of a soon-to-be-built solar energy farm that will cover a full square mile.
The dizzying spike in oil prices this year has focused the world's attention on energy like no event since the supply shock of the mid-1970s. But unlike the relatively brief oil embargo that forced Americans to wait in gas lines, this crisis is having a more profound effect on global business and causing significant suffering in both the developed and underdeveloped worlds, as the cost of transportation and even food soars out of reach for some.
Like most economic shifts, the oil shock offers significant opportunity along with massive challenges. "Companies that are nimble will find ways to cope and ultimately outdo their competitors," says Business School Professor Hau Lee, one of the foremost experts on supply chains. Indeed, the energy price run-up has sparked a burst of creativity as global business adapts and investors pour money into a panoply of new, energy-related technologies.
One of the most active "clean-tech" investors, Vinod Khosla, MBA '80, confidently predicts that biofuels made from agricultural waste (he's the backer of a startup that will do just that) will push the price of oil down to $35 a barrel by 2030. He argues, however, that politically popular ideas like driving hybrids (which he does) or putting solar panels on the roofs of homes in foggy San Francisco won't make a dent in global warming or the energy shortage. "Anything that requires people to change their habits has a low probability of success," he said in a recent interview with the San Francisco Chronicle.
Meanwhile, major enterprises are reconfiguring operations to cut fuel costs. Some changes are as simple as more efficient routing of delivery drivers or redesigning packages so more can be carried on a single pallet. Others businesses, though, are undertaking the complex task of moving manufacturing resources from Asia to sites closer to domestic markets in the United States and Europe.
"I guarantee that every major international [company] is working on this," says Michael Marks, who for more than a decade headed Flextronics, one of the world's largest contract manufacturers, and is now a lecturer at the Business School. "Some manufacturing will move closer to end markets, and areas like Mexico and Eastern Europe will be the beneficiaries," he says.
Tesla Motors, for example, a maker of electric cars backed and briefly headed by Marks, had planned to build batteries in Thailand, ship the 1,000-pound units to the United Kingdom for installation and then ship the cars to the United States. But with shipping costs out of control, the company has decided to make the batteries and assemble the cars in California, according to a report in the New York Times.
Agribusiness is being challenged as well. Faced with sharply rising costs for diesel fuel and fertilizer, farmers in the American West are turning to "no-till" technologies to minimize the number of times they run heavy equipment through fields, even as demand for ethanol pushes commodity prices higher and consumes perhaps 20 percent of the U.S. corn crop.
Severe as it was, the oil shock of the 1970s had a fairly simple origin: A group of producing countries drastically cut production as a means of political leverage. The causes of today's crisis are far more complex.
Economic growth in Asia has increased demand for oil at a time when world oil production is approaching a peak, and pressure to halt global warming presents policy makers with contradictory priorities. "If tomorrow there were no global warming problem, I would say the price of oil would come down quite a bit within six months," says Professor Frank Wolak of Stanford's Economics Department. "We have the technology to turn coal into liquid fuel, but people cannot make the investment not knowing whether they will be punished down the road for the carbon."
Think Local
TESLA'S DECISION TO RECONFIGURE its manufacturing and supply chain seems radical, but manufacturers now pay $8,000 to send a freight container from Shanghai to ports on the East Coast of the United States, compared with $3,000 eight years ago when oil sold for $27 a barrel, according to a report by analysts Jeff Rubin and Benjamin Tal of CIBC World Markets. Should the price of crude hit $200 a barrel, shipping the container would cost $15,000.
Reports like that of the Canadian investment bank have prompted speculation that years of globalization may be reversed and that we could even see a massive return of industry to the United States. That would be an exaggeration, says Stanford's Lee, who consults with companies on their supply chains and directs the University's Global Supply Chain Management Forum. "The U.S. no longer has the labor force or the network of second- and third-tier suppliers," he says.
Instead, what Lee calls a mixed strategy—in which a company builds a bare bones or base product in one location close to existing suppliers, and then ships it to a second location for final assembly—is gaining ground. Consider the garment industry: Dyeing and weaving are expensive, but cutting and sewing garments together is relatively cheap. "It's the low-cost steps in the process that will move closer to the markets," he says.
EMC, a $13 billion seller of network storage equipment and related software, has embraced that ethic, says Trevor Schick, the company's vice president for global supply chain management. "Fuel is a big driver, of course, but we also want the flexibility of building products closer to the market," he says. That flexibility leads to faster turnaround and lower overall inventory in the supply chain.
EMC's contract manufacturing in China has been scaled back, with some of that work now performed at plants in Mexico, Hungary, and the Czech Republic, Schick says. The changes are likely to be permanent, although the company will always shift resources back and forth as market conditions change, he says. Computer maker Dell also has added plants in Poland, Brazil, and North Carolina to be closer to customers.
Running on Empty
YOU DON'T HAVE TO BE A CARD-CARRYING Green to be pessimistic about the chances for a quick, meaningful increase in the supply of oil. Nor is there a fast way to increase the refining capacity for oil we do have. Consider these talking points from the National Petroleum Council, which advises the U.S. secretary of energy:
- The world currently uses about 86 million barrels per day of oil—40,000 gallons every second.
- New, large oil discoveries can take 15 to 20 years from exploration until production begins. The Thunder Horse platform, for example, in the U.S. Gulf of Mexico cost $4 billion and is not yet operating eight years after discovery and has a capacity of 0.3 percent of world oil demand.
What's more, the popular preconception that higher oil prices will lead to a fall-off in demand, which in turn will lower prices, is overstated, says Professor Jim Sweeney, director of Stanford's Precourt Institute for Energy Efficiency. "The oil market has only small elasticity of demand," he says. How small? About 0.1 percent, which means that every 10 percent increase in price reduces demand by just 1 percent. If, as some experts argue, the market is twice as elastic as Sweeney estimates, price increases would still be 5 to 10 times as large as the reduction in demand, he says.
Sweeney also is skeptical of another popular notion: that the price of oil has risen much faster than demand because of speculation by hedge funds and other large players in the markets. "The fundamentals are doing better to explain why prices have [increased so fast]. It doesn't seem out of line in terms of classic supply and demand theory."
Increased demand in Asia has undoubtedly pushed up prices, but uncertainty in the minds of investors is also a powerful element, says Ehud Ronn, PhD '83, a professor of finance at the University of Texas at Austin. "Stated differently, when nervousness or uncertainty is high, energy prices are elevated due to the risks of a shock—almost always, a supply-side shock—which would cause prices to spike," he says. "That high-risk premium implies that if the source of risk goes away, the risk premium would decline and so would prices."
There's no doubt, Ronn says, that the oil market was pricing a good deal of risk into the commodity during the summer of 2008, when prices escalated rapidly. What's less certain is the source of the risk. One possibility he raises (with the caveat that he is not a political scientist): fears that the Bush administration in its waning days will strike Iran when the president no longer has to fear electoral consequences.
Geopolitics aside, higher energy prices have the effect of making new oil exploration and production technologies economically feasible. Tony Meggs, Sloan '90, the former head of British Petroleum's technology arm, recently founded Carbon Storage PLC, which is exploring the use of carbon dioxide generated as an industrial byproduct to rinse out oil trapped in old wells. Many natural gas reservoirs contain large amounts of carbon dioxide that is released into the atmosphere when the wells are tapped. Capturing it and using it to scour old wells would address both global warming and the oil crisis, he says.
Meggs worries that global warming will take a backseat to the oil shortage. "Six months ago," he said in August, "I would have said that CO2 legislation will be here in two or three years. But in this hot political season, as people realize they are spending 20 percent or 40 percent of their income on energy, legislation will be hugely watered down."
The double whammy of global warming and an energy crisis has made the building of new nuclear plants in the United States once again thinkable, even to some environmentalists who had seemed implacably opposed to the idea.
"The political climate has changed; concerns over global warming have been a rejuvenator for our industry," says Mayo Shattuck III, MBA '80, CEO of Constellation Energy, which is seeking clearance to build a nuclear plant in Maryland. Constellation would use a new and arguably safer reactor design now being installed in plants in France and Finland. Given the uncertainties, Constellation won't issue a public estimate of the plant's cost, but documents on file with the Securities and Exchange Commission indicate that $9 billion is in the ballpark. Meanwhile, the $21 billion company, with a helping hand from regulators, is encouraging its customers to use less energy.
Decoupling, a regulatory tactic long favored in California, but now gaining wider currency, changes the structure of utility rates by separating profits from the volume of sales to consumers. In effect, companies like Constellation subsidiary Baltimore Power & Light are repaid for the fixed costs of power transmission (plus a reasonable return for investors) but make no extra profit for selling additional energy. "It gives us the incentive to push conservation," Shattuck says. Early results indicate that when consumers are given the means to do things like shift energy use to off-peak hours, and are given a reasonable break on price, they will use substantially less power, he says.
Fair enough. But what about transportation, which accounts for some two-thirds of the petroleum used in the United States (less in the rest of the world)? While Khosla makes an interesting point when he says that driving a hybrid doesn't do much to reduce energy use, it's worth noting that a good deal of thought—and capital—is being directed at improving today's still relatively inefficient green automobiles.
GSB lecturer and former Intel Chairman Andy Grove notes that new technology can become a disruptive force as it develops, even though its first iterations are often less than satisfactory. Witness the first rudimentary personal computers that, within a relatively short time, transformed the economy. The automobile industry, however, has been waiting for advances in battery technology to appear before making a serious effort to produce electric cars, he wrote in a recent issue of the American. Grove suggested temporary tax breaks and deep electricity discounts to spur enterprising owners of existing gasoline guzzlers to convert to dual-fuel systems. "We must accelerate conversion [of automobiles] to electricity in a major way," he said.
One company that isn't waiting for better batteries is Better Place, a venture-funded startup with an innovative twist on the electric car concept. Here's the idea: Customers will purchase a specially equipped car from a Better Place auto manu- facturing partner (so far Nissan and Renault have signed up) and buy a subscription plan. The plan is analogous to cellular phone service, "but instead of selling minutes, we're selling the number of miles you expect to drive," says Josh Steinmann, Sloan '07, who heads the young company's business development efforts.
Better Place uses batteries with a range of about 100 miles, well short of what Steinmann calls "the 500-mile ideal, but plenty good enough to start." When Better Place goes into full commercial operation in Israel and Denmark in 2011, customers will be able to charge their cars at a network of thousands of parking-meter-sized charging stations. For trips that exceed 100 miles, they will stop at depots (100 or so in Israel) to swap batteries.
Food vs. Gas
THE WORLD BANK DROPPED A BOMBSHELL last spring by blaming the use of corn-based ethanol for as much as 75 percent of the recent spike in world food prices. The controversial report said that successive droughts in Australia, thought by some to be a significant driver of higher grain prices, had only a marginal impact. Instead, it argued that the drive for biofuels by the United States and the European Union had by far the biggest impact on food supply and prices. The Bush administration, by contrast, put the ethanol-related increase at about 3 percent.
The World Bank estimate may be high, but it's clear that "the agricultural system worldwide cannot handle the demands of fueling our cars," says Rosamond Naylor, senior fellow at the Freeman Spogli Institute for International Studies at Stanford.
Enter Coskata, a startup backed by Vinod Khosla and General Motors, which is building plants that can turn agricultural waste, garbage, or even tires into ethanol. Coskata has more in common with biotech startups than with refiners because a key part of its process uses microorganisms as a catalyst to break down organic material.
It will be able to make ethanol at a cost of about $1 a gallon, says Wesley Bolsen, MBA '04, chief marketing officer and business development chief of the Warrenville, Ill., company. Now running a pilot project, the company expects to finish a larger demonstration plant in Pennsylvania that will be used by GM to test biofuels in its autos. Plans to build a California production facility that should come online in 2011 were close to being announced as this article went to press.
Ausra, another Khosla-backed startup, is attempting to solve a different part of the alternative energy puzzle: economical solar power. Rather than use expensive photovoltaic panels, essentially large semiconductors, Ausra uses large mirrors to reflect sunlight and boil water to drive steam turbines.
Executive Vice President John O'Donnell says his company expects to build and operate plants such as the one proposed for the Carrizo Plain, and also will sell components made by its 130,000-square-foot factory in Las Vegas.
Pacific Gas & Electric has agreed to purchase power generated by the Central California plant, which will generate 177 megawatts of power, enough to power 120,000 homes. If all goes well, O'Donnell says, Ausra will obtain a permit by the end of the year and start construction in 2009.
A big downside of solar energy, indeed of many alternative technologies, is the inability to store electricity generated during the day. Ausra has an ingenious solution: Steam fills a high-pressure vessel and condenses into water. When the pressure is lowered by opening a valve, the water boils, thus forming steam to turn the turbine and generate electricity during the evening or on a cloudy day.
Frank Ramirez, MBA '83, looked at the energy storage problem and came up with a solution that relies not on heat, but on cold. His company, Ice Energy, has developed a hybrid air conditioning system that stores energy by freezing water in an insulated tank. It cools by circulating chilled refrigerant from the tank during the day to the evaporative coil of the conventional A/C system, eliminating the need to run the energy-intensive compressor. Ice is then refrozen each night when demand is lower and electricity is often less expensive.
A key challenge faced by utility companies, Ramirez says, is the heavy use of air conditioning during the day. Shifting much of that load to the evening could reduce the need to build expensive and dirty peaker plants.
Taxes and Global Warming
FORWARD-LOOKING AS IT IS, the clean-tech revolution could be slowed, if not derailed, by an old-style dispute over taxation. If Congress fails to set a long-term policy regarding tax incentives for solar power, it may be difficult to build the installations planned by Ausra and others. The difficulty is less the size of the tax break than uncertainty over the amount, O’Donnell says. Without knowing total operating costs, including taxes, it becomes difficult, if not impossible, to negotiate the price of power delivered to utility companies like PG&E.
Besides taxes, environmental concerns could be an obstacle to alternative power. A number of solar projects have been proposed for public land in sunny Western desert areas, but environmental opposition to individual projects could drag out the lengthy federal government-permitting process run by the Bureau of Land Management. (In the case of the Carrizo Plain project proposed for private land, Ausra is seeking a license from the California Energy Commission.) Issues to be addressed on individual projects could include what effect the installation will have on endangered species, on water use, and on the land itself.
How those conflicts, not to mention many others, will be resolved, is not yet clear. Solving the problems posed by the energy shortage without further damaging the environment or imposing draconian lifestyle changes will take an enormous amount of money, talent, and effort. In an essay written earlier this year, Stanford Professor Paul Romer offered a hopeful perspective:
"It is the discovery of new formulas that really matters. Economic growth, true improvement in the quality of life, is possible because we keep making these discoveries … and there is a virtually unlimited scope for discovery of valuable new formulas."