Solutions to End-of-Chapter Questions

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Solutions to End-of-Chapter Questions

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Chapter 1: An Introduction to Energy Finance and Economics

Chapter 3: Energy Economics: Past, Present, and Prospects for the Future

Chapter 4: Sustainable Energy: Myths and Realities

Chapter 5: A Brief Introduction to the Petroleum Industry: From Crude Oil and Natural Gas to Petrochemicals

Chapter 6: The Economics of Renewable Energy

Chapter 7: How Our Political Views Affect Our View of Energy Prices

Chapter 8: Oil and Gas Accounting

Chapter 11: Real Options and Applications in the Energy Industry

Chapter 13: Financing Large Energy Projects

Chapter 14: Financing Bio-Fuels Projects: Case Study Lessons

Chapter 17: Risks in Trading Energy Commodities

Chapter 25: A Case Study on Risk Management: Lessons from the Collapse of Amaranth Advisors LLC

Chapter 1: An Introduction to Energy Finance and Economics

1. List and describe advantages and disadvantages of renewable fuels and renewable energy sources.

Answer: Very briefly, renewables are considered “green” energy sources. They replace conventional fuels and energy sources and can be locally produced. As the name implies, they are renewed and are not depleted.

Disadvantages are: They are not economically feasible without government subsidies. They require a large footprint in land area. Bio-fuels may take food crops that could be used in a different way. Energy from renewables is generally not easy to transport to where it is needed. Renewables don’t have the energy density that conventional energy sources have.

Refer to Chapter 4 for more discussion on this topic.

2. This question requires you to think outside the box. What types of alternative fuels or energy sources can you think of that are not discussed in the chapter? Disregard economic or practical considerations, and brainstorm possible future sources of energy. Use the Internet if you wish to assist in your answer.

Answer: Answers will vary, and there is no right or wrong answer to this question.

3. Using the Internet, research the history of energy usage. What were the great transition points, and what drove those transitions?

Answer: Answers should include a complete discussion about the transition from wood to coal and then to oil in the United States. Chapter 3 in the book has excellent coverage of this topic. Refer to that chapter for more information.

4. What is “peak oil” and who came up with that theory? (You will have to do a little research for this.)

Answer: Peak oil is the point in time when the maximum rate of petroleum extraction is reached, after which the rate of production is expected to enter terminal decline. Global production of oil fell from a high point in 2005 at 74 million barrels per day (mmb/d), but has since rebounded, and 2011 figures show slightly higher levels of production than in 2005. There is active debate as to how to measure peak oil, and which types of liquid fuels to include. Most of the remaining oil is from unconventional sources. M. King Hubbert created and first used the models behind peak oil in 1956 to accurately predict that U.S. oil production would peak between 1965 and 1971.

5. What topic would you like to see included in this book that is not covered? Why?

Answer: Answers will vary depending on personal opinion. There is no right or wrong answer to this question.

Chapter 3: Energy Economics: Past, Present, and Prospects for the Future

1. Discuss U.S. energy consumption trends by sector (i.e., transportation, power, residential, and commercial).

Answer: The chapter discusses U.S. energy consumption trends by sector with a focus on petroleum. The discussion begins with transportation, followed by power, residential, and commercial sectors. There are a few lessons from the 20 percent decline in overall U.S. petroleum consumption between 1978 and 1983 that apply today, and the chapter covers these trends by sector. Exhibit 3.6 shows U.S. petroleum consumption by sector in thousands of barrels per day for the period 1949 to 2010.

As shown, the largest overall growth and greatest changes have occurred in the transportation sector. By 1978, petroleum use comprised about 97 percent of the total energy in the transportation sector. Currently, bio-fuels (labeled as biomass in the exhibit) represent 4.2 percent, petroleum use is down from a 97 percent market share to 92.8 percent, and natural gas plays a minor role with 2.7 percent of the market. (See Exhibit 3.7.) Most of the bio-fuels increase took place in the past decade with the mandated switch from methyl tertiary butyl ether (MTBE) to ethanol.

The lesson from the use of fuel in the power sector is that major shifts can occur in as few as five years. As shown in Exhibit 3.9, in the two-decade period beginning in 1963, petroleum consumption went from 250,000 barrels per day (b/d) to 1.7 million b/d and then back to 500,000 b/d. The rise was slower than the fall because it required the construction of new petroleum-fired power plants. In a sense, it served as a bridge to the increased use of nuclear energy and natural gas, but the collapse was primarily driven by price.

Residential and commercial use of petroleum is relatively small and currently accounts for only 5.4 percent of petroleum usage, as shown earlier in Exhibit 3.4. These sectors' share of the petroleum market steadily declined since the peak of 17.7 percent in 1961.

2. The largest energy consumption sector in the United States is ____________, and the fastest-growing energy consumption sector is ___________.

Answer: transportation, transportation

3. For the residential sector, why has propane use remained strong and not declined like heating oil?

Answer: The answer is twofold. First, propane is more versatile than heating oil. It is used for cooking and in hot water heaters as well as for home heating. Second, like heating oil, it is ideal for rural applications where natural gas lines are not available and may reflect the large number of families who want to live farther out in the country than the suburbs.

4. For the period 1949 through 2011 for the transportation sector, why has overall petroleum use continued to remain strong while other sectors have seen more declines?

Answer: The fundamental difference between the transportation sector and the others is that means of transportation do not consume petroleum in a fixed place. Automobiles, trucks, trains, airplanes, and ships all carry their energy with them. Liquid fuels have a high Btu density and are an efficient way with respect to volume and weight to carry your energy with you. To compete, alternative fuels and their containers need to have size and weight comparable to gasoline tanks and be able to deliver enough energy to travel 350 to 400 miles without refueling. Until then, fuel switching is very limited.

5. What event marked the beginning of the oil industry in the United States?

Answer: In 1859, Colonel E. L. Drake struck oil in the tiny village of Titusville, Pennsylvania. This event marked the beginning of the oil industry in the United States. However, it was another 60 years before oil became a major player in supplying energy in the United States.

6. How does energy demand growth in Organization for Economic Cooperation and Development (OECD) countries compare to non-OECD countries? Which two non-OECD countries have the fastest-growing demand?

Answer: Energy demand growth has declined from 1995 to 2012 for OECD countries but has continued on an overall positive growth trend for non-OECD countries. Exhibit 3.16 presents petroleum consumption in developed countries (OECD). Consumption has not recovered from the recession, averaging 45.6 million b/d in 2011, which is down 540,000 b/d from the prior year. Consumption will likely fall an average of 300,000 to 400,000 b/d in 2012 unless the economies recover.

The post-recession gains in world petroleum use are concentrated in the non-OECD countries, as shown in Exhibit 3.17. After the dip in 2008 and early 2009, non-OECD use returned to what is almost a trend line. In the past eight years, the average increase was 1.4 million b/d per year compared with an average annual decline in the OECD countries of 400,000 b/d over the same period.

For non-OECD countries, China and India have the fastest-growing demand based on total energy consumption. (Note: While not discussed in the chapter, Saudi Arabia currently has a higher percentage demand growth rate than India.)

7. According to the forecast for 2035 described in this chapter, what is the fastest-growing renewable energy source?

Answer: Measured on the total percentage added, the answer is biomass. Biomass is projected to supply 9.4 percent of energy in 2035, compared to 4.4 percent in 2010. To summarize all sources: Approximately 8 percent of U.S. energy needs was supplied by renewable energy sources in 2010, and this is expected to grow to 14 percent by 2035. For the various renewable fuels, the amounts of U.S. energy supplied are (2010 versus 2035): solar power (0.01 percent versus 0.2 percent), hydroelectric power (2.62 percent versus 2.8 percent), geothermal energy (0.2 percent versus 0.5 percent), biomass (4.4 percent versus 9.4 percent), and wind power (0.9 percent versus 1.7 percent).

8. Go to the American Petroleum Institute (API) website at and download the latest “Energizing America” report. What are the current energy forecasts for the United States and world future energy needs (in terms of both additional new energy needed and percentage change)? How much is expected to be supplied by oil, natural gas, coal, and renewables?

Answer: Answers will vary depending on when the report is downloaded. This question is included so that the chapter can be continually updated to current trends. Refer to the chapter for current forecasts.

9. From the API report in the preceding question, list the largest oil companies based on proven reserves. How many of the top 15 are national oil companies, and how many are investor-owned companies?

Answer: Answers will vary depending on when the report is downloaded. This question is included so that the chapter can be continually updated to current trends. Refer to the chapter for current forecasts.

10. Go to the International Energy Agency (IEA) website and download the latest Oil Market Report, which should be available at Investigate the latest supply and demand fundamentals, and describe your observations. Describe the main highlights that the report covers. (Note: Go to the IEA main website at if the previous link has changed.)

Answer: Answers will vary depending on when the report is downloaded. This question is included so that the chapter can be continually updated to current trends.

11. Go to the Energy Information Administration (EIA) website at and download the latest Short-Term Energy Outlook research report. Skim the report and answer the following questions:

a. Summarize the energy outlook for the short term.

b. What is the current supply and demand outlook?

c. Are there any areas of concern for supply, demand, or geopolitics?

d. What are the current forecasts for gasoline prices, crude oil prices, and natural gas prices for both the United States and globally over the next year? Are prices forecast to increase or decrease? Why?

e. What are the forecasts for U.S. renewable fuels?

Answer: Answers will vary depending on when the report is downloaded. This question is included so that the chapter can be continually updated to current trends. Refer to the chapter for current forecasts.

12. What impact did the Iraq-Iran War and the two Gulf Wars have on oil supply in Iraq and Kuwait? What happened to oil prices?

Answer: With these impacts, we see that major supply interruptions led to spikes in oil prices. The price run-up of the late 1970s was a result of two supply interruptions. The first was a drop in Iranian oil production due to the Iranian Revolution. Although oil production dropped dramatically, two-thirds of production was restored within a few months. Before it could fully recover, however, Iraq attacked Iran and the oil production of both countries collapsed. This drove prices to the highest level in current dollars since 1859. See Exhibits 3.21 and 3.22. Oil supply dropped, and prices increased. The next major price spike happened during the first Gulf War when Iraq invaded Kuwait in 1990. Once again Iraqi oil production and exports collapsed, but this time along with Kuwaiti production (Exhibit 3.23) instead of Iranian production.

13. Discuss whether higher oil prices are a cause of recessions or whether recessions lead to lower oil prices. Describe historical events as examples.

Answer: Major oil supply interruptions lead to price spikes, and sharply higher oil prices can be a major contributor to recessions. However, that same exhibit indicates that recessions lead to lower oil prices. For example, the rising prices in the late 1970s and the back-to-back recessions of the early 1980s led to a drop of almost 20 percent in U.S. consumption between 1978 and 1983. There was a similar reaction in other developed countries. It took the United States two decades to return to the 1978 level of consumption. The situation was similar but not as extreme in most developed countries. The lower level of consumption led to a price collapse. The 2008 recession with its anemic recovery has had a similar impact on OECD countries’ oil consumption. The weak European economies have put downward pressure on oil prices in the second quarter of 2012.

14. In the graphs of real petroleum prices, we used the Gross Domestic Product (GDP) deflator. Download the composite refiner acquisition price from the EIA website, obtain the GDP deflator and the Consumer Price Index (CPI) and Producer Price Index (PPI) prices, and then show the real prices of oil in current dollars using each of the price indicators. Discuss the difference in the results and identify the most appropriate deflator to use. (Hints: Do consumers use crude oil? Which producers make up the PPI?)

Answer: Answers will vary depending on when the report is downloaded. This question is included so that the chapter can be continually updated to current trends. Refer to the chapter for current forecasts.

Chapter 4: Sustainable Energy: Myths and Realities

1. List and discuss five energy myths.


1. Soft-energy illusions. Various pundits argue that soft energy—various types of renewable energy sources—can meet future energy needs. “The overall energy supply draws a bit more on renewable flows, but hardly on the small, decentralized units of the soft vision. The verdict is clear: Soft and small has not worked as predicted.”

2. Peak oil is here. Oil’s “declining share of the global commercial primary energy supply spells no imminent end of the oil era; given the very large remaining conventional and nonconventional resources, oil will continue as a major contributor to the world market during the first half of the twenty-first century.”

3. Carbon dioxide can be sequestered. Carbon capture sequestration “cannot provide enough storage in time to avoid further substantial increase in emissions; it will be a major consumer of energy, erasing half a century of efficiency gains in electricity generation; there will always be concerns regarding the safety of long-term storage and the possibilities of leaks; it will be an expensive undertaking; and it will carry significant liability risks.”

4. Bio-fuels can replace refined oil for transportation. “More important than the fact that liquid bio-fuels cannot displace refined oil products in transportation is that they should not.”

5. Energy transitions will occur rapidly. “A world without fossil fuel combustion is highly desirable. . . . Coming energy transitions will unfold, as the past ones have done, across decades, not years.”

2. How many wind turbines would it take to produce 100 percent of electric power used in the United States in 2011?

Answer: For 20 percent of electric power we need about 200,000 wind turbines. So for 100 percent we need around 1,000,000 wind turbines.

3. How many years, at a minimum, will current supplies of fossil fuels last? Discuss.

Answer: The current supplies of fossil fuels will last at least for the next 50 years. There are supply disruption and high oil prices as a result of increasing demand. Interestingly, these factors are causing governments and businesses to attempt to reduce their reliance on oil and coal, which will lengthen the useful lives of oil and coal prior to depletion.

4. If all transportation fuel needs were met by ethanol (bio-fuel), how many acres of farmland would be needed, and what percentage of arable farmable land in the United States is that?

Answer: 406,250 square miles = (406,250  640) acres of land would be needed to meet the transportation fuel need. This is 55 percent of the arable farmable land in the United States.

5. Are bio-fuels a sustainable energy source? Why or why not?

Answer: The idea that bio-fuels are sustainable far into the future is a myth because they are not sustainable in the present. They may become sustainable if technological breakthroughs occur (e.g., using algae for fuel).

6. The chapter discusses the results of a survey of 900 consumers on their perceptions of various aspects of nine energy sources. From this survey, the authors identify four potential myths held by consumers about sustainable energy. Based on your ideas, suggest ways in which consumers can be educated on energy so that they understand the differences between energy myths and realities.

Answer: It is critical to consider economics when establishing the sustainability of energy sources, and it is important to set a time frame when identifying the myths and realities of sustainable energy. Without an economic consideration, sources such as solar power appear to be sustainable when in fact they are not. It is important to make decisions about energy usage that are grounded in economic and scientific reality, not based on ignorant acceptance of political or societal views.

Chapter 5: A Brief Introduction to the Petroleum Industry: From Crude Oil and Natural Gas to Petrochemicals

1. List and describe the three segments of the oil and natural gas industry.


1. Upstream—exploration, drilling, and extraction of oil and gas.

2. Midstream—transportation to processing and refining facilities.

3. Downstream—processing into products and sale of the products.

2. List and describe the three main processing steps of refineries.


1. Distillation. Separating the crude oil into different parts based on the boiling points of the different components of the oil.

2. Conversion. Taking the different components and remaking them by various processes, including cracking, or breaking the molecules into smaller pieces, and reforming and isomerization, which recombines molecules into more useful products.

3. Treatment and blending. Taking the products and blending various components together to meet specifications for the product.

3. What are the major finished petroleum products from the refining process? List in order from lightest to heaviest.


1. Natural gas

2. Liquefied petroleum gas (LPG)

3. Gasoline

4. Kerosene and jet fuel

5. Distillate fuel oil (gas oil, diesel, heating oil)

6. Residual fuel oil (fuel oil, bunker fuel)

7. Asphalt

8. Petroleum coke

4. Assuming a 3-2-1 crack spread, what is the crack spread if gasoline is $125.00 per barrel, distillate is $119.00 per barrel, and the cost of crude oil is $113.68 per barrel?


Crack spread = 0.667($125) + 0.333($119) – $113.68

= 9.32

5. List and describe five of the petrochemical building blocks that are the primary feedstocks for the chemical industry.


1. Naptha—gasoline-type hydrocarbons

2. Natural gas—methane

3. LNG—ethane, propane, butanes, and pentanes

4. Ethylene—a two-hydrocarbon molecule with a double bond

5. Wax—hydrocarbons heavy enough to form a heavy, waxy substance

6. You just purchased a bottle of your favorite soft drink at the convenience store. This bottle is most likely made from which of the following plastics?

  1. Polyvinyl chloride

  2. Low-density polyethylene

  3. High-density polyethylene

  4. Polyethylene terephthalate (PET)

Answer: d. PET

7. What is a SAP? What type of polymer is it? What is its main use?

Answer: Superabsorbent polymer is a cross-linked polyacrylate that can absorb over 100 percent of its own weight. It is used in diapers.

8. You just ordered a meal from your favorite fast-food restaurant. Look around at the items you are using and what other people are using. What petroleum products are you and other people using in the restaurant? More specifically, list the items you and other customers are using that are derived from petrochemicals and specify which of the petrochemicals are used.

Answer: Containers are styrofoam, utensils are polystyrene, cups are waxed paper or styrofoam, drink lids are polystyrene, and straws are polypropylene.

9. Look around your home. List five goods made from plastics and explain which plastics make up the good along with describing the good. Use five different plastics examples.


1. Food storage container (e.g., Tupperware)—polypropylene

2. Detergent—made from an ethylene derivative

3. Athletic clothes—nylon

4. Water pipes—polyvinyl chloride

5. Carpet—polyester

10. ____________ is a system of classifying crude oil based on its specific gravity, whereby the greater the gravity, the lighter the oil.

  1. Full cost

  2. API

  3. FASB

  4. Sweet

  5. Sour

Answer: b. API

11. What is a hydrocarbon?

  1. A chemical containing water

  2. A molecule with carbon and hydrogen

  3. A nonpolluting fossil fuel

  4. A compound produced at hydroelectric plants

Answer: b. A molecule with carbon and hydrogen

Chapter 6: The Economics of Renewable Energy

1. What is levelized cost, and how is it calculated?

Answer: The foremost method of estimating the cost of electricity is known as levelized cost. The levelized cost of electricity is the present value of the total cost of building and operating a power plant over its economic life, converted to equal amounts per watt-hour of electricity generated by the plant (Heptonstall 2007). In other words, the levelized cost is the price that equates the net present value of revenue from the plant with the net present value of the cost (Borenstein 2011; EIA 2010). It is the equivalent of average cost in microeconomics.

2. Levelized cost can be expressed in either real or nominal values. This statement is:

a. True

b. False

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