US Energy Independence Can Be Created

Ed. note: This piece was first published on Robert Rapier’s R-Squared Energy Blog.

By Paul Stinson and Robert Rapier

First thing, on this day after the U.S. presidential elections I would like to congratulate President Obama on his reelection. My top prediction for 2012 – made nearly a year ago and reiterated many times since — was that Obama would easily win reelection, primarily because all of the Republican contenders had baggage that was likely to keep some of the Republican base from voting. Therefore, I did not believe that the country was likely to see any major shift in energy policy, and the next four years will be similar to the past four years.

It has been a while since I hosted a guest post in my column here. I decided to host this one by Paul Stinson from North Hampton, New Hampshire because he offers up a thought-provoking concept that I have not encountered elsewhere. I am uncertain whether a proposal such as this could work, but I thought it was worth offering up to readers because it is really outside-the-box thinking. It has some similarities to my own proposals for incentivizing renewable energy production that would shift risks from the taxpayer into the private sector, and it is a detailed piece of work.

Paul’s background is that he has a BS in chemical engineering from Texas A&M (1979), and he previously worked on synthetic fuels production for ARCO and Exxon before moving into power production. He then worked for AES Corporation where he built three large power plants in his first ten years. One of those power plants, a 700 MW CCGT, was in the UK where we was exposed to the ideas of CfDs (the topic of his guest post) and how they could be used to finance infrastructure and alter market structures to be more favorable to consumers. In his later years at AES he was involved in acquiring and integrating about ten different power companies in Kazakstan, the Republic of Georgia, and the states of Illinois and Indiana. He finished his time with AES working as Principal Engineer for Power Generation.

US Energy Independence Can Be Created

The US government can create an appropriate level of energy independence by causing up to four million barrels per day of additional transportation and heating fuels to be produced from North American energy sources by auctioning long-term financial hedges (Contracts for Difference) to firms offering the best terms for building appropriate conversion facilities. An appropriate level of energy independence is one that a) greatly reduces volatility of worldwide oil markets, b) eliminates the perceived need for political and military intervention in the Middle East and other unstable regions, and c) allows sensible and transparent competition among alternate sources of basic energy.

Contracts for Difference

A Contract for Difference (CfD) is a type of futures contract under which a “Seller” pays to the “Buyer” the difference between the value of an asset at contract time and its reference value. If the value is negative, the Buyer pays the Seller the difference. For our purposes the Buyer would be an appropriate arm of the US Government, for example the Department of Energy (DoE). The Seller is a company that has won in an auction a CfD by proposing the most attractive terms.

The underlying asset in this case shall be a unit of basic energy, such as crude oil of particular qualities (or a mix of qualities). The asset may also be another unit such as BTUs of natural gas or gallons of ethanol.

A volume term is required relevant to the asset, for example, 10,000 barrels of crude oil equivalent per day.

The reference value, or strike price, is a term that would be competitively bid, such as $70 per barrel, or $5 per million BTU. Some portions of the strike price may be escalated by appropriate inflators. Sellers shall bid a strike price that they determine based upon the fixed and variable costs of the conversion facility they propose (or is required by DoE) to build as a condition of the CfD.

The fixed portion of the strike price includes such elements as depreciation, interest, return on equity and fixed operating and maintenance (O&M) costs. The variable portion of the strike price shall include such variable costs as input energy, production based taxes, and other variable O&M costs. Sellers may propose that certain portions of the strike price escalate with factors that are beyond the Seller’s reasonable control in order to reduce the cost of capital for the proposed project.

The CfDs under consideration here are highly bespoke products. Examples of some of the other terms are:

1) Contract Term: The length of the CfDs should be no longer than required to support financing of the conversion facility. The term could be a key element of a Seller’s bid. Terms of up to twenty years may be required.

2) Settlement Periods: This is the period of time for which difference payments due are calculated. It is likely that daily settlement periods shall be appropriate.

3) Non-firm or firm basis: Payments for any settlement period can be firm or non-firm. A firm basis means that difference payments are required for every settlement period whether or not the related conversion facility is operating. If the basis is non-firm, then difference payments are only required to the extent that the conversion facility is operating. A non-firm basis reduces the operating risk of the project and reduces cost of capital. Even with a non-firm basis, the project has plenty of incentive to operate in order to earn revenue.

4) Change of law: CfDs shall be required to protect the Seller in the event of a Change of Law that affects the Seller’s cost of operating the conversion facility. In such a case, an appropriate adjustment is made to the strike price.

5) Performance Standards: Appropriate performance standards for the conversion facility, e.g., availability, environmental performance, production levels, etc. may be incorporated to protect the Buyer. In this case, the CfD may be terminated if the Performance Standards are not achieved.

6) Step-in rights: The Buyer (DoE) should have the right, but not the obligation, to assume the position of the equity participant to the extent that the project fails to meet the Performance Standards.

7) Buyer’s Directions: The strike price may be defined in terms of an Availability Payment and an Energy Payment. In this case, terms my give the Buyer the right to shut down the conversion facility in order to mitigate excessively low energy prices. The Buyer would then pay to the Seller a reduced level of difference payments based upon the Availability payment portion of the strike price.

8 ) Project development period: The CfD may include a fixed period of time for development of the project. If financing is for the project is not closed by a date certain, the Buyer may terminate the CfD.

9) Project construction period: The CfD may include a fixed period of time for financing, construction and commissioning of the conversion facility. If the project does not begin by such date certain, the Buyer may terminate the CfD.

10) Choice of technology: The DoE may specify certain types of technology for certain tranches of CfDs to be issued, in accordance with the wishes of Congress, or the US may be agnostic with respect to choice of technology.

The Benefits of this Approach

For the Seller, the benefit is a guaranteed fixed price for basic energy that is correlated to the value of the product of a conversion facility that the Seller proposes to build. The Seller can then raise finance for construction of the facility on capital markets using readily available models of project finance. The Seller sells all of the product(s) from the related conversion facility in open markets at prevailing prices. Difference payments under the terms of the CfD help to make-up any shortfalls in revenues for the Seller that result from prices less than the strike price. The Seller pays additional revenues due to market prices in excess of the strike price to the Buyer.

For the US government there are a multitude of benefits:

1) First is that an agreed number and capacity of conversion facilities shall be constructed that will decrease dependence of the country on foreign sources of energy;

2) The increased level of energy independence reduces or eliminates the strategic interest of the US in unstable areas of the world, such that the US need not intervene politically or militarily in such regions:

3) The US may choose only those project for which it projects that the strike price will remain below the relevant index value on average for the life of the CfD. Therefore the US government, if it chooses wisely, can earn revenue for providing the price hedge;

4) Even if the government issues too many CfDs, and therefore drives basic energy prices too low, the economy shall benefit more from low energy prices than tax revenues must increase to make payments due under the CfDs;

5) US balance of trade is improved;

6) US gains flexibility in dealing with geopolitical foes that are also major energy producers;

7) Construction of the various conversion facilities will drive a large economic stimulus using private capital that is currently be sitting on the sidelines. The size of private investment resulting from 4 million bpd is approximately $400 billion;

8 ) Through an open and transparent competition, the US Government can support commercialization of technologies such as cellulosic ethanol and others without taking any technology risks. The US government takes only knowable additional price risk, i.e., higher strike prices.

9) Sensible carbon emission limits associated with operation of conversion facilities can be incorporated if the costs are determined by the competition to be reasonable. For example, in the combustion process that fuels a coal gasification process, technology may be economically applied to capture the carbon dioxide generated and sequester that in tertiary oil recovery.

10) US recaptures some of the lead from China in energy conversion technologies;

11) The US does not accept any risks of:

1. Construction cost overruns;
2. Technology risks;
3. Operating performance;
4. Cost of energy inputs to conversion facility

12) The government shall have the option to sell the CfDs to credit-worthy entities such as institutional lenders if that is considered desirable in the future.

For the US taxpayer, the current structure of the market is not working as well for consumers of energy as it is for producers of petroleum. The US Government will take a reasonable “long” position (up to 4 million barrels per day of oil equivalent) to offset in part the 20 million barrel per day short position in petroleum. The effects are:

1) If energy prices continue to rise, the rise should be less than if the conversion facilities were not built, and there will be revenues from the CfDs to their government;

2) If, as expected, the basic energy markets are less volatile, consumers will benefit from that stability;

3) If basic energy prices drop below the level of the strike prices in the CfDs their government will have to pay out under the CfDs, but the overall savings for consumers will more than offset those payments;

4) The risk to reward ratio is very much in favor of taxpayers: The proposal allows the US to leverage its own energy to lower costs for the entire country. Let us assume that in a worst-case over-build of conversion facilities at 4 million barrels per day, the US government has to pay out $44 billion per year under the CfDs (see difference payment scenarios below) because world crude oil prices dropped to an average of $40 per barrel. But versus current prices of $100 per barrel and a crude oil consumption of 20 million barrels per day, a reduction to $40 per barrel will save the about $440 billion per year on crude oil for the country.

Examples of difference payment scenarios

How much money might flow to or from the US government under different scenarios? Let us presume that the CfDs were issued to various project companies in a total volume of four million barrels per day. Let us further suppose that the average strike price is $70 per barrel referenced to a composite index of various world crude oil prices. Next let us consider three possible results:

1. If world oil prices averaged $100 per barrel, the US government would receive ($100 – 70) x 4 million x 365 days/yr = $44 billion per year from CfD counterparties.
2. If world oil prices were dropped to $70 per barrel because of the additional US-based production, the US government would receive nothing, but gasoline prices would drop by $0.75 per gallon.
3. If world oil prices dropped to $40 per barrel because of the additional production/recession, the US government would have to pay counterparties ($40 – 70) x 4 million x 365 = $44 billion per year. Gasoline prices drop by $1.50 per gallon

Thus it shall be very important to avoid over-production of US based energy such that world oil prices drop precipitously. This concern will likely limit the size of the program to no more than 4 million barrels per day, phased in over a period of years.

How May this Proposal be Implemented?

This approach to energy independence shall require legislation to be passed. Thus, Congress would need to conduct hearings on the basic proposal to get guidance from energy companies, Wall Street, consumer advocates, environmental advocates, etc.

Enabling legislation would be passed that would provide for:

1) Rules governing competition for CfDs to be issued by DoE within a reasonably short time frame.

2) Parameters to be set: Total volume, size of contracts, and key terms of CfDs, target energy sources.

3) DoE to conduct first tranche (500k-1 M bbl. per day oil equivalent) of bidding for CfDs within an initial period, say one year. This time period is necessary for development of sensible proposals by developers.

4) Awards of CfDs are made based upon evaluation criteria: Strike price, start dates, technology, other major terms such as availability, fixed vs. variable components of strike price, likelihood of development success.

5) The program is then revised based upon learning from first tranche.

6) Subsequent tranches (each 1 M bbl./day oil equivalent) conducted by end of each subsequent year. Subsequent tranches may require Presidential determinations based upon the US economy, world energy prices, experience to date, etc.

7) If desired by Congress, fast-track environmental approvals for qualifying conversion facilities.

8 ) Professional financial management of the government’s interests in the program, including management of the government’s responsibilities under the CfDs.

One Example of an Innovative Conversion Project

Let us suppose that a company wished to finance the building of infrastructure and retrofitting new and existing diesel trucks to operate on compressed natural gas. A portion of the savings to trucking companies and operators that choose to participate must pay the total cost of the project and returns to equity. So the project developer must seek a way to lock in the savings between the cost of natural gas and the cost of diesel oil.

In order to do this, the cost of operating trucks on natural gas fuel to truckers from the project’s facilities must be kept below the cost of operating on diesel fuel. Most of these cost factors such as the difference in energy consumption per mile can be known and projected. The one cost factor that is speculation for the project developer is the basic energy cost of natural gas vs. diesel.

Let us say that the project developer could buy gas reserves today at prices that translate (including all costs such as the financing of the purchase of the reserves and the new infrastructure) through compressed natural gas fueling of diesel trucks to a cost today of $3 per gallon of low sulfur diesel fuel. Let us suppose that there are sufficient truck owners that would contract for the conversion of portions of their truck fleets and enter into long-term agreements to purchase compressed natural gas for a portion of their requirements, so long as they could be assured that compressed natural gas would have a cost per ton-mile of freight less than that for diesel. Let us simply suppose that this discount translates to $0.50 per gallon of diesel. And let us suppose the volume of diesel to be displaced by natural gas is 50,000 barrels per day.

Let us further suppose that the cost today of diesel fuel is $4 per gallon and the natural gas, if purchased in the ground, could be supplied to trucks at an apples-to-apples price equivalent to $3 per gallon of diesel. Today that would represent quite an opportunity. But it would take a large investment to purchase (or contract for) gas reserves and to build the necessary infrastructure.

The one big risk remaining for the developer, and for which there is no long-term hedge in the current market, is the risk that diesel prices will drop well below the assumed necessary sales price of $ 3.50 per gallon. If that happens, the natural gas project would be uneconomic and the project would likely become bankrupt.

There are a number of factors that affect the price of diesel. Among them are distribution costs, taxes, and the cost of crude oil. The project developer may be able to strike regulatory agreements with respect to taxes that will provide that compressed natural gas will never be at a disadvantage with respect to diesel fuel. The relative distribution costs for natural gas and diesel can be known and may represent a relatively small risk. But the project developer currently has no way to hedge the risk that crude oil prices could drop in the future below the level necessary to support the long term viability of the project. Hence financing at reasonable levels is not available.

On the other hand, if the US government was offering CfDs on a competitive basis, the project can be bid into the program at a price of diesel (or the correlated crude oil price) that reflects the minimum diesel price necessary to support the compressed natural gas project. If in future the diesel or crude price drops below this strike price, then difference payments from the US government will be enough to support the project and keep it viable until such time as prices may rise again. If in future diesel prices rise, the increased revenues from sale of compressed natural gas at higher prices will allow the project to pay difference payments due to the government.

The CfD can be structured so that difference payments were based upon actual sales of compressed natural gas, up to the volume of 50,000 barrels per day of oil equivalent. In this way, the US government takes no risk of production of natural gas, no risk of bankruptcy of trucking companies, no operating risk of the distribution infrastructure, and no risk of construction and build-out of the infrastructure.

On the other hand, the project developer can finance the entire project on the strength of the CfD that effectively locks in for the project a minimum margin of price between diesel fuel and compressed natural gas.