As oil prices surge through $140/barrel at the time of writing, surely one can at least count on the invisible hand of the market to drive further exploration and production and ultimately bring more supplies on line, right? Or perhaps, more ominously, high oil prices presage a darker future of shortage and conflict as global oil fields pass their geological “peak”? In fact, both positions miss a crucial point about the dynamics of the world oil market — that it is increasingly animated by the counterintuitive behavior of the state-owned oil and gas giants that now control the vast majority of the world’s hydrocarbon resources.

“On average national oil companies (NOCs) extract resources at a far lower rate than international oil companies (IOCs), leaving about 700 billion barrels of oil effectively ‘dead’ to the world market.”So-called “national oil companies,” or NOCs, own about 80 percent of the world’s proven reserves of oil, a percentage that has been on the rise as the persistent high price environment encourages countries to assert even tighter control over the rent streams flowing from their resources. NOCs are curious and variegated beasts, and, contrary to the popular imagination, some are highly capable both technically and organizationally. Brazil’s Petrobras is an acknowledged world leader in deepwater drilling, while Norway’s StatoilHydro is highly regarded for its competence and transparent business practices. Saudi Arabia’s national champion, SaudiAramco, is secretive to the outside world but generally considered to be a well-run, technically capable organization. At the other end of the continuum, government infighting and micromanagement hobble Mexico’s Pemex and Kuwait’s KPC. Once-independent PDVSA in Venezuela has been remade by President Hugo Chávez into a government puppet that spends liberally on social programs but consistently undershoots its production targets. And indeed some national oil companies are hardly oil companies at all — Nigeria’s NNPC, for example, is mostly a rent-seeking bureaucracy.

What NOCs do share in common as distinct from the familiar international oil companies (IOCs) is being answerable to a host government, which inevitably brings with it some focus on objectives other than simple profit maximization. Typically, an NOC arises originally from the desire of resource-rich governments (“principals”) to gain more effective control over resource extractors (“agents”) by creating an oil champion owned by the state. Prior to NOC formation, governments are frequently (and often justifiably) wary of exploitation by the foreign oil operators providing hydrocarbon extraction services. Lacking a deep understanding of the costs of production, states are simply unable to be sure they are taxing their agents appropriately. In addition to enhancing control over the hydrocarbon sector and the revenue it brings, states may hope for other benefits from the NOC: cheap energy to fuel a growing economy, employment and development of local industry to support the hydrocarbon sector, or even foreign policy leverage derived from control of key resources.

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A detailed study of NOC performance and strategy at the Program on Energy and Sustainable Development at FSI suggests a useful way of thinking about the effects of NOC resource domination on world oil and gas markets. Price versus quantity supply curves from classical economics assume that increased price will spur efforts to expand supply. Unfortunately, the counterintuitive reality for NOCs is that, when it comes to expanding supply in the current high-price environment, most either 1) can but don’t want to or 2) want to but can’t. The end result is what one could call a “backward-bending” supply curve — additional price increases do little or nothing to boost supply.

“The world has plentiful hydrocarbons in the ground, but that’s where many of them are going to stay due to the unique organizational and political dynamics of the NOCs.”In the “can but don’t want to” category are resourcerich governments that have decided they cannot assimilate any more money. Already, their investments are running into political resistance around the globe — witness Dubai’s failed attempt to purchase U.S. port management contracts, CNOOC’s failed bid for Unocal, or the increasing calls for curbs on the activities of sovereign wealth funds. Nations may decide they have enough cash and are better off leaving resources in the ground where they safely await monetization at a later date.

In the “want to but can’t” camp are countries and their NOCs that are simply unable to provide the stable political and regulatory climate to support additional build-out of expensive production and transport infrastructure. This situation is particularly common for natural gas, where long investor time horizons are needed to bankroll the multibilliondollar capital costs of pipelines or liquefied natural gas (LNG) terminals.

Meanwhile, international oil companies are left on the sidelines salivating helplessly over the vast reserves in NOC hands. Venezuela’s Orinoco region could yield hundreds of billions of barrels of heavy crude, but the government and a nowpliant PDVSA invite favored countries and their NOCs to explore rather than selecting the operators most capable of extracting the challenging but plentiful resource. Technical expertise and massive investment are required to fully develop vast Russian gas fields including Kovykta, Shtokman, and Yamal, but IOCs already burned by nationalizations and shifting rules in these and other Russian ventures are unlikely to be in a position to supply enough of either. In the face of dwindling resources they can tap, IOCs will need to diversify their business models, perhaps tackling technologically challenging options like oil sands or liquids from coal in conjunction with the carbon storage techniques that could make these palatable from a climate change perspective. Ironically, the only “easy” oil for IOCs has become oil that is geologically and technologically difficult.

While oil price is dependent on many factors (including global economic health) and is impossible to forecast with certainty, one can confidently predict continued tight supply of oil and gas, especially given global demand that will be propped up indefinitely by rising consumption in China and India. The world has plentiful hydrocarbons in the ground, but that’s where many of them are going to stay due to the unique organizational and political dynamics of the NOCs. Leverage over the market is weak; measures to reduce demand for oil and gas (though politically unpopular) or to spur development of alternative fuels and associated infrastructure (though slow to develop at scale) may be all that we have.

Michael Wara and David G. Victor's recent work "A Realistic Policy on International Carbon Offsets" addresses problems with the world's largest offset program, the UN's Clean Development Mechanism. Wara and Victor argue that much of the CDM investment doesn' actually meet the UN's crucial additionality standards, and they outline ways to fix the problem.

David Victor Discusses Climate Policy, Offsets, and Incentives in the Wall Street Journal

In the News: Wall Street Journal on July 23, 2008

Income from carbon offsets has become French chemical manufacturer Rhodia SA's most profitable business. The WSJ estimates payouts to the firm from projects in Brazil and South Korea could total $1 billion over seven years, raising questions about the incentive structure of the CDM. David G. Victor argues that carbon markets are not sending the appropriate signals to the developing world.

• » Wall Street Journal

Michael Wara and David Victor Address the Role of Offsets in California's Cap and Trade Plan

In the News: Science Magazine

California's plan to cut carbon emissions 10% by 2020 relies on offsets as a part of a cap and trade scheme. Michael Wara points out the challenges that face the state as it designs its offset program, and David G. Victor sheds light on difficulties faced by the world's largest offset program, the UN's CDM protocol.

• » Science Magazine

Michael Wara Discusses Coal and the CDM

In the News: Wall Street Journal on July 11, 2008

The CDM Executive Board recently approved several gas-fired power plants under the UN's carbon offset scheme, opening the door for subsidizing coal generation and stoking controversy. Michael Wara questions the additionality of such projects and argues subsidies are better spent on other clean-energy development.

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• » Wall Street Journal

By most measures, including Kuwait Petroleum Corporation’s ability to meet its own targets, the enterprise performs poorly.  Many of the problems are traceable to the profound dysfunction and fragmentation of the government, which translate into excessive interference and incoherent governance of the sector.  Government ministers are appointed by the Emir, but then these same ministers face withering scrutiny from the elected National Assembly, encouraging excessively cautious behavior.  Sector strategy reflects the whims of the oil minister, but five different people have held this post since 2000.  Unworkable governance structures inhibit effective strategy and execution: for example, the oil minister may approve a decision in his role as chair of the board of KPC and then overturn it with his ministerial hat on.  Bureaucratic requirements including extreme micromanagement of procurement and a tortuous budget process make it nearly impossible for KPC to run like a normal oil company.  On top of these problematic interactions with government, management and engineering talent within the company itself are generally weak, notwithstanding the presence of some excellent and knowledgeable senior managers.  People are given posts with insufficient experience and knowledge—a reflection of a governance system laden with political interference in the appointment and promotion of personnel and, increasingly, removed from the frontier of the industry.

In recent years these fundamental problems have been disguised by relatively high oil prices.  The small population and large accumulated reserve funds have helped paper over the cracks, and thus these severe problems in the oil sector could persist for a long time without creating a crisis in the country.  At the same time, increasing geological challenges in Kuwaiti fields, popular resistance to more deeply involving international oil companies, and political gridlock that makes it difficult to resolve problems quickly have created a dangerous situation for the sector.  If oil prices slip as the cost basis rises and KPC lags in performance, the problems could unfold quickly in a society where the population has become used to living in a rentier society with extensive and expensive benefits and pension rights.

Carbon Capture and Storage (CCS) technologies form a key piece of virtually all roadmaps for global carbon dioxide (CO2) emissions reductions---many studies predict that CCS will contribute 20-50% of the necessary CO2 emissions reductions by 2100. To assess actual progress of CCS projects towards fulfilling these expectations, the PESD Carbon Storage Project Database tracks all publicly announced CCS projects worldwide.

The first version of the PESD Carbon Storage Project Database, developed by PESD researchers Varun Rai, Ngai-Chi Chung, Mark C. Thurber, and David G. Victor, was released on June 30, 2008. Through careful examination of numerous information sources, the database groups all CCS projects into three categories according to the probability of their completion: currently operating (100% likelihood), possible (estimated 50-90% likelihood), and speculative (estimated 0-50% likelihood).

The authors observe that even under the aggressive scenario that all “possible” projects are indeed realized, this will result in about 60 Mt CO2/yr of reductions worldwide by 2025, far short of the 300 Mt CO2/yr of reductions that are projected as technologically feasible using CCS by 2030 in the U.S. alone.

The PESD Carbon Storage Project Database will be updated regularly. The authors welcome comments and feedback that will help improve the database, including identification of other projects which should be included or refinements to the probabilities and storage estimates for specific projects.

The Clean Development Mechanism (CDM) is a means for industrial nations, known as Annex 1 countries, to meet their greenhouse gas emissions reductions targets by taking credit for reductions from projects they fund in developing countries. The idea is that projects to reduce emissions will cost less to develop and implement in the developing countries where technology is further behind. Industrialized countries can achieve more reductions via investment in the developing countries, achieving greater emissions reductions for less sunk cost. At least this is the idea under the Kyoto Protocol. A researcher at the Program on Energy and Sustainable Development (PESD), Michael Wara says this, in fact, is not how the CDM is working.

Wara lectures at Stanford Law School, teaching the popular class International Environmental Law. A graduate of Stanford Law School, Wara also has a PhD in Ocean Sciences from the University of California, Santa Cruz. His doctoral work on the interaction between climate change and oceanatmosphere dynamics in the tropics echoes in his current research on the CDM. He understands the science of greenhouse gases and how they affect Earth and its climate. One of those greenhouse gases is HFC-23, a byproduct of manufacturing refrigerants. HFC-23 is one of the gases countries targeted to reduce under the CDM; it can be eliminated rather easily and has been seen as the “low hanging fruit” of the CDM. In fact, more than half the greenhouse gas reductions of CDMs to date have been reached via reducing HFC-23 in developing counties. For the reductions, the project sponsor countries receive credits to put toward meeting their own reductions targets. These credits are called Certified Emission Reductions or CERs.

This is where Wara noticed a big discrepancy between what was credited through the CDM and what was actually happening on the ground. The CERs are not just feel-good pieces of paper that countries collect as proof of their doing good but are certifications of equivalent reductions of one metric tonne CO2 emissions. Carbon is the standardizing greenhouse gas and so regardless of what greenhouse gas is reduced with the CDM the sponsoring country is credited with CERs. But these “carbon credits” have a value—carbon is a traded commodity on many global markets. Wara could directly compare the CDM effect versus the credits issued. Since the cost of implementing the reductions was known or could be calculated, and since the credits were standardized to a greenhouse gas being traded on an open market, Wara could quantitatively critique the CDM.

Wara’s finding showed a major flaw in the CDM design. Looking at the large percentage of greenhouse gas reductions met within the CDM by eliminating HFC-23, the value of the credits created by these reductions were more than four times as valuable as the cost of implementing the reductions. This is not small change, as billions of dollars worth of CERs have been credited for the projects. What is more, the credits for eliminating the HFC-23 byproduct of manufacturing refrigerant were far more valuable than the refrigerant itself, creating incentives to build these manufacturing plants in order to cash-in on the CERs. Exposing these loopholes has brought attention to Wara’s work. He has presented his findings at numerous conferences and published his report (Nature 445, 595-596 (8 February 2007) doi:10.1038/445595a) and derivatives broadly. Wara continues to study the CDM and the global market for greenhouse gases and the post-Kyoto regime for reducing their emissions.