S2, E1: Slaying Thermodynamic Dragons
S2, E1: Slaying Thermodynamic Dragons
Series 2: previously published on LinkedIn February 28, 2023 (minor edits)
It is popular to attack the various colours of hydrogen by deploying energy efficiency arguments. In this four-part general rebuttal, I will discuss blue hydrogen first and then by the time the series is completed, I will have covered green hydrogen too.
Production Efficiencies
It may seem obvious that blue hydrogen must be more expensive than the natural gas feedstock it comes from, but is it really that simple? How simple can it be when it runs counter to everything we should know about commodity markets?
Things can be related to one another in many different ways that have no bearing on how we value them. Do raw materials and the products that are created with them have a fixed relationship? In a physical sense there is a relationship but it is not fixed. As assets depreciate/degrade over time, the physical properties erode and economically, their scrap value becomes a bigger proportion of what you can sell them for. Value is entropic. By default, all the value-adding manufacturing processes that went into producing an item, are inconsequential sunk costs when it rolls off the production line.
If we decarbonise natural gas in order to deliver blue hydrogen, there will be a process energy overhead plus, a corresponding reduction in energy content. It may seem obvious that blue hydrogen must be more expensive than the natural gas it comes from, but is it really that simple? How simple can it be when it runs counter to everything we should know about commodity markets?
I happen to think we can do better with a different market construct for energy but that is not the situation we are in.
The reality is that the cost of acquisition has little to do with market pricing which is always dictated by demand relative to supply. Put another way, the relative value of any two commodities are not fixed, and that variation is due to market forces. This also applies to energy pricing which somewhat counterintuitively, has nothing to do with production costs or energy content. I will give examples of both shortly.
Were that not the case energy-fluids with known energy densities would not fluctuate on the market, or at the very least, there would be fixed offsets between commodities like oil and natural gas as they moved up and down together. Nothing like that happens.
Oil hit $0.01 a barrel before falling to as low as negative $40 and eventually settling at negative $37.63, the lowest level recorded since the New York Mercantile Exchange began trading oil futures in 1983. The low prices for West Texas Intermediate oil come as demand for oil has fallen 30 percent as people quarantine because of the coronavirus, leading to a massive surplus of unneeded oil and fuel. Negative pricing reflects a willingness of oil producers to pay futures traders to deal with the excess oil.
'Oil trades at lowest price in history after slipping into negative pricing', The Hill, Rebecca Beitsch, April 20, 2020
The fact that oil went from over $140 to -$40 a barrel in ten years might be enough to prove to you that pricing is not related to energy content in the same way someone trading in corn may have no opinion on whether it is tasty. I think that here I could rest my case for the defence of economically viable hydrogen, but I am not above hammering my point home like a reluctant tent peg, to make sure.
The oil price plunge in 2020 is fundamentally different from the sub-prime mortgage crash (which I write about in a different series of articles). In the latter case the value of large tranches of mortgage debt was based on false future-value; this resulted from the incorrect assumption that the majority of mortgages would eventually be repaid. In the case of oil the value of the energy content was never in question, what faltered was the demand for that value and therefore the price; another price impact was the logistic problem of dealing with a glut. It was a demand price shock that had nothing to do with value.
Price is what you pay. Value is what you get.
Warren Buffet
This is why I make the distinction between different types of value in my own work but that is not the global construct we have. Commodified hydrogen will have to obey the market as it is.
The Energy Divorce
The chart below compares the price performance of two energy-rich fluids. These are rolling daily averages. Let me tell you straight up that I am going to use this to illustrate that the markets are indifferent to energy content.
The blue line is West Texas Intermediate (WTI) on the New York Mercantile Exchange (NYMEX) and the orange trace represents the spot price according to the Henry Hub Natural Gas. The latter is the preeminently important distribution site for US natural gas.
NYMEX Crude Oil vs the Henry Hub Natural Gas Spot Price, Microtrends
As a rapid introduction to what this chart is showing us, on the left scale we see the price of a barrel of oil in US$ and the right hand scale is for natural gas measured in US$ per million BTUs.
Incidentally the vertical grey bands indicate periods of economic recession and without wishing to digress I can say in passing that the behaviour of certain energy cartels during those periods is informative.
Gas is benchmarked on energy content but also, indirectly, so is oil because we know that a barrel of WTI has energy content of 5.8 million BTUs. The energy content of a barrel of crude for any given grade can also be assumed to be constant. WTI is identified as sweet, light crude and readily refined, which is detail at the level that markets use.
Why then is the price-relationship between WTI and natural gas not static?
It is because the market trading is not greatly influenced by energy content. If anything, in market terms, energy content is merely a means to assess price performance retrospectively.
Same but Different
Consequently, like any other pair of unconnected commodities you care to pick, you can see that their prices move independently of each other on separate markets. Those prices converge and momentarily reach equivalence, before diverging, often swapping dominance dynamically. What we can say of this, we can say of any commodity, which is that the price is an emergent property of the market and not of not of value.
But of course, it's important to remember that this is not a comparison between two unrelated commodities, and I won't dodge it. Oil and gas must influence the availability of each other on both the supply and demand sides regardless of whether or not we are aware of it. On the supply-side, they are often comingled in their production which can complicate the economics in terms of separation processes and even gas compression. Am I being contradictory by acknowledging this? No, I am merely stating that although these are influential factors on production economics, the market does not care about them.
I'll give an example. After the 2014 oil collapse some ageing platforms in the North Sea were found to have lift costs of around $60 a barrel; a fact that had zero impact on the selling price of their product. That crude could be pumped out of the desert for a few dollars a barrel was always true; it was not a secret and it made no difference to the price, until of course, those taps were cranked open a little. Therein lies the difference between operating within a market and controlling it.
On the demand side oil and gas can, in some applications, be mutual substitutes so their availability can impact each other. However, although that may influence demand, that all happens downstream of commodity trading. This is not something the market is bothered about in real time.
Returning to the WTI/gas chart now. Perhaps you're unconvinced that this tells us very much and you may even question whether we can really draw useful comparisons between barrels of oil and and the far larger volumes of gas at standard temperature and pressure. You may also note that they are products with very different downstream handling requirements. Yet the merit of the comparison is the fact that both commodities are fluid substrates that are wanted for the energy they carry.
Let's start by zooming in to take a closer look at two areas in the chart.
So a million BTUs delivered as natural gas costs $10.48 but the equivalent energy in oil costs roughly $26.16/5.8 = $4.51 per million BTUs. You might rationalise that since oil is more energy dense it is going to be cheaper, or you may convince yourself that because natural gas is transported at higher pressures, the equivalent energy must be more expensive. But, if that is right, how does it explain the next image?
So here a million BTUs delivered as natural gas would cost $4.33 but the equivalent energy in oil costs roughly $99.97/5.8 = $17.24 per million BTUs.
To summarise: in the first case energy from oil was less than half the price of equivalent energy from gas, yet in the second case, energy from oil is over four times more expensive. Wherein is this supposed relationship between energy and price?
I picked these spots by casual inspection and you may well find better examples of what I am talking about. The interactive chart is here.
At risk of labouring a point that I once thought too obvious to make, the pricing of energy rich fluids is predicated on availability and therefore effectively decoupled from energy value.
Market makers pick up commodities and stock they are familiar with at best price. What dominates their decision making is the instantaneous availability of both upstream supply and downstream demand - irrespective of what is driving them.
... in the first case energy from oil was less than half the price of equivalent energy from gas, yet in the second case, energy from oil is over four times more expensive.
For an operator the choice between leaving natural gas in the ground or decarbonising it to have a saleable product is obvious. But that is not the only choice they have right now. By transitioning the demand side we make that be the choice.
What the public can also demand are assurances that carbon is captured and the product is really blue. The barriers to this are many but they reside in policy, consumer resistance, the influence of special interest groups and lack of scaling strategy.
There are no particular technical obstacles to this and we can design all the assurances.
This is why I can't take the energy efficiency/economic arguments against hydrogen seriously. They surely don't understand the market dynamics, or that producers do not control prices ...
I am not saying that market price is not confounded by many different factors including, influential subjective opinion, the behaviour of crowds and the politics that govern logistics and access in a specific territory. Just that everything that affects pricing is either reducible to the availability of the commodity or perhaps more accurately, the market's collective opinion of that availability. There are no exceptions to this.
The spike in the natural gas price on the right side of the original chart was not due to the gas becoming more energy rich but because the Russian invasion of Ukraine had quite suddenly made it less available.
This is why I can't take the energy efficiency/economic arguments against hydrogen seriously. They surely don't understand the market dynamics, or that producers do not control prices unless they have a monopoly or are part of a cartel.
As for upstream economic viability of hydrogen production and operator margins... I think we can let them worry about that because they seem to be pretty good at making money.
Besides, as consumers we don't currently base our buying choices on company margins or energetic costs. When you go to Sainsbury's to pick up your ration of tomatoes do you consider the energy that went into them? Do you select such produce on the basis of whether or not they were grown on a Spanish vine or in a UK hothouse? Do you chose anything based on the energy cost of production or are you looking at the price tag like most people?
If you simply don't trust energy companies you are still on the hook. How could the absence of heating competition be good for domestic electricity bills? Isn't it worth considering that the commodification of hydrogen might be the very thing to prevent you from being trapped in an energy monopoly?
Pricing on the Floor
The immediate trading floor valuations result from fallible opinion, but since that opinion effectively emerges from markets and also feeds forward into them, they create the reality. No matter how right or wrong the market is about value, what it is prepared to pay is dominated by availability, to the exclusion of all other considerations of value; at least within existing market constructs.
In SE E2/4: The Hidden Dimensions of Value, I will start to outline what I think is wrong with our evaluation of energy options. In the meantime we can positively value what we want but also negatively value what we don't by the choices we make, or rather, by the ones we don't throw away. How else can the markets get the message? The demand signal is in the only language they understand.
This is the first in a four part series (series 2) that I will put up over the next few days. This first part makes the case that energy content and pricing are entirely decoupled to the extent there is no fixed relationship between different feedstocks.