Strategy for an energy-starved world: Go coal!

David Dapice, Yale Center for the Study of Globalization, Medford

Amidst continuing violence in the Middle East and political turmoil in some other major oil-producing countries the issue of energy security is again on the front burner. With oil price rising to a peak of US$40 a barrel countries have been looking at alternative energy with a greater urgency.

This heightened sense of urgency, fortunately, has come at a time when there is evidence that a new approach using existing resources and technology can provide alternative energy to many countries.

A glimmer of good news recently appeared that many might have missed. China signed an agreement with SASOL, a South African energy and chemicals firm, to build two coal-to-liquid fuel plants in China.

These plants, costing $3 billion each, are reported by the Financial Times to jointly produce 60 million tons of liquid fuel (440 million barrels) a year. Since China imported 100 million tons of oil last year, these plants would give China substantial control over its domestic energy situation, though its demand is growing fast.

The raw material and capital costs of a barrel of fuel would fall under $10 and other costs would not bring total costs over $15. Earlier coal-to-liquid projects in China were smaller in promised output (rising to 5 million tons a year by 2008) but are said to cost about $10 billion.

If these newspaper reports about the SASOL costs and volumes are correct, they would indicate a breakthrough. The SASOL costs are also far less than those of current US technology. One experimental plant in Pennsylvania will cost over $300 million for 250,000 tons a year.

This would make its capital costs per ton of oil over ten times those of the SASOL-China plants. (The US Department of Energy has been involved with several "clean coal" projects of high cost and dubious merit, but that is another story.)

Coal resources of 1 trillion tons are widely distributed around the world. Many countries, including China, India, Russia, Ukraine, Germany, Poland, South Africa, the US, and Australia have extensive coal deposits that would last 100 years or more at current rates of exploitation.

However, coal is a highly polluting fuel when burned directly and also emits a lot of global-warming carbon dioxide emissions. The SASOL technology, a third generation Fischer-Tropsch process, was developed in Germany and used in World War II, and later in South Africa.

It has long been too expensive to compete with standard crude oil. On the plus side, sulphur and other pollutants such as ash and mercury are removed -- the sulphur can be sold as a byproduct - and CO2 is segregated and can be injected underground. If hydrogen is needed for fuel cells, these plants can also provide it. In the near term, the gasoline and diesel produced are high grade and clean, meeting even future "clean diesel" requirements of the US.

The real question is if these plants can be built and reliably produce fuels for less than $20 a barrel. SASOL already produces 150,000 barrels a day from coal. (Conversion from natural gas is cheaper and SASOL is in the process of switching its feedstock to gas in South Africa).

Each of the Chinese plants would be four times as large as the existing SASOL plant, and scaling up can involve difficulties.

If SASOL can make these larger plants work at the publicized costs, this technology could be used by many other nations -- rich and poor -- who are willing to forego periods of very cheap oil for more security. Indeed, even oil-producing Indonesia is looking into a coal-to-liquids plant as it now imports oil.

This technology also works in converting coal to natural gas at a cost of $3 to $3.50 per million BTU. Since current natural gas prices in the U.S are roughly double that, it would appear that coal to gas is also an economically viable technology.

This coal-to-liquids technology would compete with the evolving tar sands technology being expanded in Canada. This technology involves the production, either by mining or extracting with steam, of heavy oil trapped in sands.

The heavy oil is then massaged into more valuable fuels. This source already accounts for a quarter of Canada's 3.2 million barrels a day output but requires natural gas to heat the tar and is energy intensive, but still has production costs of under $20 a barrel.

Is there a downside to rapidly adopting these technologies? Yes, from a global welfare perspective. Now, onshore oil production costs are usually under $5 a barrel. If prices are higher, somebody (the country owning the oil or the company producing it) gets the difference between the price and the cost.

If we switch to $15-$20 costs from these other technologies, then there is no surplus of price over cost, or a much smaller one. To use an economic phrase, the "rent" on oil production is destroyed in a quest for self-sufficiency. While true, the instability in oil prices -- as well as the threat of terrorist disruptions to supply -- are such that many nations might be happy to use their own resources to produce this vital input.

They are no worse off if oil can be produced at $20 a barrel, unless the price temporarily plunges below that level as it did in the late 1990's. A stable price and supply prevents very expensive disruptions.

None of this answers critics who are properly concerned with global warming. Subsidies to hybrid or other highly efficient vehicles are probably needed to reduce emissions from increasingly popular personal transportation.

Higher efficiency standards in buildings and appliances are an alternative to politically difficult carbon taxes. In the longer term, fuel cells burning hydrogen and producing only water as a waste product are promising -- but still far from economic feasibility. Even solar energy could become competitive soon in producing electricity.

Overall, the coal-to-liquids technology is only one element of an integrated program that is needed to deal with fuel security, local pollution and global warming issues. But, even alone, it could bring an element of stability to world oil prices and thus also to the global economy. In addition, if it redirects efforts from geopolitical competition and even conflict to investment and efficiency, it is a welcome development.

The writer is Associate Professor of Economics at Tufts University and the economist of the Vietnam Program at Harvard University's Kennedy School of Government.