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Musings from the Oil Patch - September 29, 2009

Musings From the Oil Patch
September 29, 2009

Allen Brooks
Managing Director

Note: Musings from the Oil Patch reflects an eclectic collection of stories and analyses dealing with issues and developments within the energy industry that I feel have potentially significant implications for executives operating oilfield service companies.  The newsletter currently anticipates a semi-monthly publishing schedule, but periodically the event and news flow may dictate a more frequent schedule. As always, I welcome your comments and observations.   Allen Brooks

Recession Over! What Does It Mean For Energy Stocks? (Top)

In comments following a speech two weeks ago, Federal Reserve Chairman Ben Bernanke stated that in technical terms, the recession is likely over.  We can now all breathe a sigh of relief following that pronouncement, even though the qualification means he still expects the economy to experience a slow recovery with unemployment continuing to rise well into next year and peaking above 10% of the work force. 

Exhibit 1.  What A Technical Recovery Feels Like
What A Technical Recovery Feels Like
Source:  Plexus Asset Management

Of course, one could say that the stock market and energy prices have been signaling the end of the recession for some months now.  How come it took so long for our banking leader to see that reality?

Exhibit 2.  Through Mid-September Recovery Well Underway
Through Mid-September Recovery Well    Underway
Source:  Yahoo Finance, PPHB

Exhibit 3.  Oil And Gas Prices Coming Together
Oil And Gas Prices Coming Together
Source:  EIA, PPHB

If we assume that Mr. Bernanke is correct and the recession is over, then the focus shifts to the shape of the recovery.  We have to assume that credit markets continue to loosen and the housing, consumer credit and commercial real estate sectors continue to strengthen and does not create an environment in which the economy slips back into recession – the proverbial double-dip.  Taking Mr. Bernanke and other economists at their word, we should expect the economy to experience sub-normal growth compared to historic patterns coming out of recessions.  This would suggest slow growth for energy demand until world economic growth recovers substantially.  Thus, there will be less upward pressure on crude oil prices during the next 1-2 years.  The natural gas market has its own problems and, until production drops due to further producer cutbacks in drilling, the lack of substantial U.S. economic growth will keep gas prices under pressure and lower than they might be otherwise.  Given this scenario, we look at the energy stocks and say much of their price recovery for this cycle may have been achieved.

A recent Wall Street Journal op-ed article on September 19th by James Grant of Grant’s Interest Rate Observer makes the case that he is bullish because history shows that “the deeper the slump the zippier the recovery.”  In reaching his conclusion he quotes Michael T. Darda, chief economist of MKM Partners, who stated, “The most important determinant of the strength of an economy recovery is the depth of the downturn that preceded it.  There are no exceptions to this rule, including the 1929-1939 period.” 

According to Mr. Grant, one reason to believe the economy will experience a strong recovery is the amount of fiscal stimulus being injected into our economic system.  He pointed out that in the post World War II era, the government has attacked recessions with an average fiscal stimulus equal to 2.6% of Gross Domestic Production (GDP) and an average monetary stimulus of 0.3% of GDP, for a combined countercyclical lift of 2.9%.  In this recession, the government has injected fiscal stimulus equal to 10% of GDP and monetary stimulus equal to 9.5% of GDP for a combined stimulus equivalent of 19.5% of GDP. 

He cited several examples of strong recoveries following steep economic recessions.  For example, in the 1981-82 recession the worst quarter of economic contraction was the first quarter of 1982 when GDP shrank at an annual rate of 6.4% matching the steepest quarterly decline during this recession.  The snap-back from that recession was strong.  Starting with the first quarter of 1983, the recovery, measured in annual rates of change, showed quarterly growth over the next six quarters of 5.1%, 9.3%, 8.1%, 8.5%, 8.0% and 7.1%.  It was not until almost two years after the end of the recession before economic growth slowed to a rate below 5%.

Mr. Grant also pointed to the recovery after the 1920-21 recession when deflation was a major issue.  Wholesale prices fell by 37% and the Federal Reserve reacted by raising interest rates and Congress balanced the budget.  The drop in prices, however, stimulated consumers and businesses to snap up the bargains they saw.  As a result, after falling by 4.4% in 1920 and by 8.7% in 1921, inflation-adjusted Gross National Product soared by 15.8% in 1922 and by 12.1% in 1923.  He also cited the fact that the last time the labor market was ravaged as much as now was in 1957-58 after which payrolls climbed by 4.5% in the first year of a two year recovery.

The final point Mr. Grant makes is that the Economic Cycle Research Institute, the leading business cycle research organization, is calling for a recovery.  The Institute has a long leading index of the U.S. economy, along with sub-indices, which are making 26-year highs and point to the strongest recovery since 1983.  The primary risk to this recovery is the health of the banking sector and its inability to provide adequate credit to finance a strong recovery.  Additionally, there are concerns about the health of the consumer as reflected in the housing and consumer credit sectors.  Without a robust consumer, who has accounted for upwards of 70% of GDP, the rest of the world’s economies will have a hard time generating growth by attempting to supply the U.S. consumer. 

The following several charts show potential problems for the U.S banking system and consumer spending.  The first two charts come from banking research firm Institutional Risk Analytics (IRA) that has performed its own stress tests on the commercial banks under Federal Deposit Insurance Corporation (FDIC) regulation.  The FDIC says it has 400 banks on its troubled bank list while IRA has assigned an “F” rating to 2,256 banks.  While Sheila Bair, head of the FDIC, says there will be a large number of banks closed during this credit cycle (95 so far this year compared to 25 last), IRA says 1,000 banks will fail.  That means we are looking at another 900 banks to go!

Exhibit 4.  A Dour Outlook On The Health Of Banking
A Dour Outlook On The Health Of Banking
Source:  John Mauldin

The assets of the banks rated “F” total $4.46 trillion.  So far in this cycle, for the banks the FDIC has closed it has been posting losses of 25%.  That rate is much higher than the banking sector suffered during the period 1980 to 1995 when insured losses averaged 11% of assets of the failed banks.  IRA’s view is that the likely loss-rate-peak this credit cycle will be two times that of 1990, or as noted by the International Monetary Fund, around 4% of total loans outstanding.  Total loans and leases held by FDIC-insured banks as of 2009’s second quarter is $7.7 trillion, implying losses of $300 billion.  If IRA’s estimate of 1,000 banks failing with losses to the FDIC insurance fund of 20-25% of assets, losses over this credit cycle would be in excess of $400-500 billion.

One concern about this recession and recovery is the role of bank credit.  A growing economy needs expanding credit.  If credit is

Exhibit 5.  Substantial Bank Assets At Risk Of Failure
Substantial Bank Assets At Risk Of Failure
Source:  John Mauldin

shrinking, the economy is receding.  As shown by this chart, since 1947 during recessions there may have been a flattening of loan volume, but not outright decline as experienced in this cycle.  Banks are restricting lending (ask E&P companies about their bank lines) as they are under pressure to raise capital to strengthen their balance sheets. 

Exhibit 6.  Falling Loans Reflect Contracting Economy
Falling Loans Reflect Contracting Economy
Source:  John Mauldin

As banks have been cutting their commercial loan and lease exposure, they have also been cutting consumer lending and credit card debt.  One reason banks are cutting their lending in order to increase earnings is because they are experiencing high loan losses.  Since the loan losses are showing few signs of slowing at the moment the pressures continue to build for banks to shrink their asset bases.  The next shoe to drop for banks will be commercial real estate loans with estimates that the losses to the banking industry from that sector could total $400 billion.  That will certainly bring down some banks and pressure others to cut lending further.  Without credit it will be more difficult for the economy to recover at a high rate. 

At this point, however, we are going to accept the optimistic case set forth by Mr. Grant and look at its implications for energy stocks and, in particular, for the oilfield service stocks.  On April 1st of last year we published an extensive article in the Musings discussing the outlook for the energy industry and a possible scenario for the

Exhibit 7.  Loan Charge-offs Still On The Rise
Loan Charge-offs Still On The Rise
Source:  Plexus Asset Management

stocks.  In that article we included a chart that we said scared us to death.  It was a comparison of the performance of the S&P Energy Equipment and Service stocks since 2000 plotted against the performance of this index for 1973-1983.  We have re-published it nearby.  In hindsight we remain amazed at how prescient the chart proved to be.

Exhibit 8.  Energy Service Stocks As Of April 1, 2008
Energy Service Stocks As Of April 1, 2008
Source:  PPHB

As we pointed out in subsequent update articles, we switched in the recent period to utilizing the Philadelphia Oilfield Service Stock Index (OSX) that tracked very closely the performance of the S&P Energy Equipment & Service sub-index of the S&P 500 from 2000 to 2008.  Even though the patterns show a slight difference from that displayed in our original chart, the history was sufficiently close that we elected to use the OSX going forward. 

Exhibit 9.  This Decade Has Mirrored 1970s Stock Performance
This Decade Has Mirrored 1970s Stock    Performance
Source:  PPHB

The data through mid-September in the next chart provided by the Bespoke Group show that energy stocks fell over 42% after the collapse of Lehman Brothers last fall, but then rallied almost 41% off their lows.  Compared to where the energy stocks were at the time of the Lehman collapse, they remain (at September 15th) almost 19% below that level.  The stock price drop last week has increased that spread.  In order to close that gap, the stocks still need to rise by more than 23%, a not inconsequential increase in the future.

Exhibit 10.  Hit To Energy Requires Large Recovery
Hit To Energy Requires Large Recovery
Source:  Bespoke Group

Another examination of our data showed that we might want to index the two periods to see more clearly how each period performed relative to the other.  The indexed performance of the 2000s shows that while the energy stocks performed well, they did not match the gains of the 1970s.  The performance also showed that the correction in this cycle was much sharper than in the early 1980s and the decline was much greater.  But now we can see that the energy service stocks are recovering. 

Exhibit 11.  2000s Gain Not As Good: Correction Worse
2000s Gain Not As Good: Correction Worse
Source:  Yahoo Finance, PPHB

As can be seen in the chart above, the last part of the 1970s performance of oilfield service stocks trended upward albeit with a certain amount of volatility.  But what happened to energy stocks after 1983?  As can be seen by the chart below (Exhibit 12), the stock market began its great bull market driven by the breaking of the grip of inflation and high interest rates that dominated the economy’s performance during the 1970s.  But at the same time, energy stocks became a boring sector for investing.  That performance difference is highlighted by the start of the divergence of the broad market and energy indices noted in the area designated by the oval.  It wasn’t until the late 1990s that energy stocks began to perform better, but certainly these stocks were underperformers for an extended period.

A contributing factor to the underperformance of energy stocks after the oil price collapse was the subsequent stability of global oil prices as shown in the following chart.  After the second oil price explosion in 1979 caused by the Iranian revolution, oil prices drifted lower until collapsing in 1986 and then essentially they traded sideways until the 1997-98 Asian currency crisis that set the stage for their sharp recovery into the early years of the 2000s. 

Exhibit 12.  ‘80s Energy Bust Started Bull Market
‘80s Energy Bust Started Bull Market
Source:  Yahoo Finance, PPHB

Exhibit 13.  Oil Prices Reflect Periods of Stability After Volatility
Oil Prices Reflect Periods of Stability    After Volatility
Source:  EIA, PPHB

Based on our analysis of oil prices over time, it appears that after periods of extreme price volatility, oil prices settle back to about half of their peak and then remain relatively stable for an extended period of time.  In concluding his WSJ prediction article, Mr. Grant stated the following:  “The world is positioned for disappointment.  But, in economic and financial matters, the world rarely gets what it expects.” 

Could that prove true for energy price forecasters and energy stock investors, too?  The idea that oil prices will rise as Bernstein Research and others have suggested: averaging $80 a barrel in 2010; $103 in 2011; $111 in 2012; and $140 by 2015, could prove a disappointment.  Maybe oil prices will fluctuate somewhere around $75 a barrel for a number of years.  That would not be surprising if the global economic recovery remains modest for a number of years.  Stable oil prices will do little to stimulate oil company capital spending and drilling activity suggesting for the service industry that “what you see is what you get.”  That likely means more adjustments to energy company business models and corporate focus.  Energy stock investors may have to adopt more modest profit expectations, too, met by smaller stock price gains supplemented by returns of capital through either stock buybacks or dividends.  This is a different expectation than held by most analysts and investors today.  Take Mr. Grant’s observation about disappointment to heart.

Administration Targets Oil & Gas Industry And Children (Top)

Last week was monumental for President Obama as he attended his first UN meeting in New York City held during Climate Week NY°C, where he led the charge for an international agreement to curb global carbon emissions.  He also appeared on the Letterman nighttime show (maybe a low-light), addressed the Clinton Global Initiative conference and then traveled to Pittsburgh, Pennsylvania, to host the leaders of the G-20 nations in grappling with how to restructure the world’s economy.  On Sunday he rested.

The theme of the UN meeting on global warming, an issue UN Secretary General Ban Ki-moon has made his principal mission in leading this global organization, was getting leaders to agree on a broad framework for addressing the climate issue.  Secretary General Ki-moon is trying to build momentum for a consensus on how much and how best world economies can rein in carbon emissions that will form a new agreement to follow-on the expiration of the Kyoto Protocol in 2012.  The agreement to be negotiated in Denmark’s capital of Copenhagen, starting in less than 90 days from now, will hopefully have all the world’s largest carbon emitters agreeing to cut their carbon emissions by a significant amount by 2020 and by an even greater amount by 2050.  The objective of the Copenhagen agreement is to reduce carbon emissions sufficiently in the future to limit the rise in global temperatures that will contribute to climate change damages to the planet and its population.  The underlying issue for the UN, the G-20 and Copenhagen meetings is the cost imposed on economies from the actions necessary to meet these emissions curbing goals.  On this issue the world’s largest economies are not in agreement.

In his talk to the UN, President Obama made several statements that give a hint of his willingness to sacrifice economic growth for climate protection.  At the start of his speech, President Obama said, “the threat from climate change is serious, it is urgent, and it is growing.”  He later stated, “We know that our planet’s future depends on a global commitment to permanently reduce greenhouse gas pollution.”  But in making his comments, President Obama also revealed one of his cherished goals, which is an anathema to oil and gas executives, cutting back the central role of that industry in meeting this country’s energy needs.  One thing President Obama didn’t do in his UN speech, which disappointed his environmental supporters, was to commit the U.S. to a hard target for reducing emissions.  The fact the Obama administration has been more willing to fight the use of 1990 as the benchmark to measure emission cuts and instead use 2005 suggests the President knows he needs some relief on compliance if he is to win any battle in this war.

President Obama told the heads of states and governments in attendance at the UN meeting, “Later this week, I will work with my colleagues at the G-20 to phase out fossil fuel subsidies so that we can better address our climate challenge.  And already, we know that the recent drop in overall U.S. emissions is due in part to steps that promote greater efficiency and greater use of renewable energy.”  Unfortunately, the U.S. government reports on reduced carbon emissions point to energy conservation and the fall in economic activity as the principal reasons for the reduction.

Before heading to these high profile meetings, the Obama administration has been unveiling its energy policy bit by bit.  His policy has a philosophical underpinning based on “green energy” as the best way to solve the global warming issue.  The first step in unveiling the Obama administration’s philosophy was the Environmental Protection Agency’s (EPA) new fuel efficiency standards for cars and trucks that link them to emissions from vehicles.  These rules were the result of the Supreme Court’s decision allowing the EPA to regulate CO2 (greenhouse gas) emissions from tailpipes under the 1970s Clean Air Act.  Under the EPA’s ruling, auto manufacturers can produce fleets that average 35.5 miles per gallon by 2016.  Alternatively, they could meet a requirement that on average their vehicles emit no more than 250 grams of CO2 per mile.  With current engine technology, these measures are essentially equivalent.

Next the EPA’s head, Lisa Jackson, signed into law a new mandatory greenhouse gases emissions reporting system for corporate America.  The new system requires companies to start reporting data to the EPA on January 1st of next year.  The greenhouse gases covered by the rule include carbon dioxide (CO2), methane (CH4), nitrous oxide (N2O), hydrofluorocarbons (HFC), perfluorocarbons (PFC), sulfur hexafluoride (SF6), and other fluorinated gases including nitrogen trifluoride (NF3) and hydrofluorinated ethers (HFE).  The reporting companies will include fossil fuel and industrial greenhouse gas suppliers, motor vehicle and engine manufacturers and facilities that emit 25,000 metric tons or more of CO2 equivalent per year.

The next pulling back of the philosophical curtain was the testimony of Alan B. Krueger, Assistant Secretary for Economic Policy and Chief Economist, U.S. Department of Treasury before the Subcommittee on Energy, Natural Resources, and Infrastructure.  In that testimony, Sec. Krueger focused on steps the government needs to take to eliminate subsidies for the oil and gas industry.  He set the stage for this radical restructuring of natural resource taxation by saying, “The Administration believes that it is no longer sufficient to address our nation’s energy needs by finding more fossil fuels, and instead we must take dramatic steps towards becoming a clean energy economy.”  After setting the stage, he moved on to focus on subsidies the administration wants to eliminate or change: oil and gas preferences (percentage of depletion accounting; passive loss limitations for working interests in wells; and two-year amortization of G&G expenditures); imposing an excise tax on certain oil and gas extracted offshore in the future; and repeal of LIFO accounting for inventories. 

Sec. Krueger’s testimony stated that tax policy should be neutral across all industries.  Using this philosophy, he went on to state that tax subsidies provided to the oil and gas industry leads to inefficiency by encouraging over-investment of domestic resources in this industry.  He further pointed out that the tax subsidies result in distortions within the oil and gas industry by favoring investment in nonintegrated companies, i.e., E&P companies.  The rest of his testimony was to show that by making these subsidy changes there would be little impact on oil and gas supplies and prices.  Sec. Krueger closed his testimony by saying, “The possibility to promote our broader energy goals at a very low cost – in terms of prices, productivity, and jobs – makes removing these subsidies sound economic and public policy.” 

We aren’t going to analyze the Secretary’s argument in this article, but understand his testimony is a window on the thinking of the Obama administration on how they will deal with energy and the oil and gas industry.  The industry is playing the role of the target sitting on that little bench at a dunking booth at a country fair – just waiting for that ball to hit the release lever sending him into the tank of water. 

The entire global warming control effort approach was spelled out in an August research report published by the London School of Economics Operational Research group supported by the Optimum Population Trust.  The study found that from a cost-benefit analysis, family planning is more cost-effective in reducing future CO2 emissions than investing in low-carbon technologies.  Specifically the study concluded that for each $7 spent on basic family planning would reduce the same amount of CO2 that would need $32 to be spent on low-carbon technologies.  While this study takes a round-about way of making the Malthusian argument that the best way to solve our global warming problem is to restrict the number of people who will live on the planet in the future.

There were three tables from that report we found interesting.  One showed the average annual carbon emissions in select countries.  The irony of the chart is that several countries with very small populations have the highest per capita emissions.  At the same time, countries with large populations have low carbon emissions. 

As a result, thinking about the message of this study, one is left to think that the authors believe family planning control should be directed towards developed countries.

Exhibit 14.  Small Population Countries Have High Emissions
Small Population Countries Have High    Emissions
Source:  London School of Economics

From this chart we have a difficult time understanding how the United States is ranked the highest country in CO2 emissions avoidance by embracing the family planning program.  In fact, the U.S. is ahead of China, which has four times the number of people.  Clearly family planning would be targeting the high-energy consuming life-style of Americans.

Exhibit 15.  U.S. Energy-intensive Life-style At Risk
U.S. Energy-intensive Life-style    At Risk
Source:  London School of Economics

But probably the most interesting table was the one showing the cost-effectiveness of family planning compared to various carbon-reducing technologies.  Notice that the core of President Obama’s energy plan – wind, solar and electric vehicles – all rank well down the list of cost-effectiveness compared to family planning.  Quite possibly the Malthusian approach hasn’t been embraced yet by the Obama administration, but then again this study only came out a couple of weeks ago. 

Exhibit 16.  Family Planning Beats Renewables
Family Planning Beats Renewables
Source:  London School of Economics

The conclusion of the study makes the point about the high value of family planning.  The study stated: “It can also be concluded that family planning is a worthwhile investment when we consider our finding against the IPPC’s 2007 observation:

“Peer-reviewed estimates of the social cost of carbon (net economic costs of damages from climate change aggregated across the globe and discounted to the present) for 2005 have a weighted average of value of US[$]12 per ton[ne] of CO2              (Bernstein 69)

“Based on the study’s findings, it is proposed that family planning methods should be a primary tool in the optimum strategy for reducing carbon emissions.”  We should watch carefully what other agendas become part of the Obama administration’s plan for energy and climate change.

Treasury’s Inconvenient Truth: Cap-and-Trade Costs Billions (Top)

A request issued under the Freedom of Information Act (FOIA) has produced ten pages of memos from internal discussions within Obama’s Treasury Department during the transition and earlier this year showing it believes the cap-and-trade bill winding its way through Congress could cost citizens billions annually in contrast to estimates issued by the Environmental Protection Agency (EPA) and the Energy Department (EIA).  At the time the House of Representatives was debating and passing the Waxman-Markey bill, estimates from the administration’s environmental and energy departments and supported by a study from the Congressional Budget Office (CBO) suggested the legislation’s cost to American families would be in the range of $98 to $175 per year.  Various think-tank analyses put the cost of cap-and-trade’s efforts to rein in carbon emissions at thousands of dollars a year per household.  Now the FOIA request has produced documents stating that Treasury officials expected the cost to be between $100 billion and $200 billion a year, or roughly $1,000 to $2,000 a family a year.  Somewhere a blogger got this information and calculated a $1,767 estimated cost per household that has been sweeping across the internet world.

The FOIA request, made by the Competitive Enterprise Institute (CEI) opposed to the legislation, sought information related to Treasury proposals involving “cap-and-trade schemes” that deal with “carbon,” “carbon dioxide” or “greenhouse gases.”  The documents were given to The Washington Times who broke the story.  The memos were authored by officials in the Treasury Department’s Office of Environment and Energy that was established by former Treasury Secretary Henry M. Paulson, Jr. in August 2008.  While the Treasury Department does not have authority to manage programs regulating carbon, the department thought it might get that authority in the future.  That belief comes from the Treasury Department being the lead agency in supporting economic prosperity and financial security.

A memo authored by Judson Jaffe of that Treasury Department office referenced President Obama’s energy policy remarks in his State of the Union Address.  It concluded that by auctioning off emissions credits under a “cap-and-trade” program, the government would receive fees “on the order of $100 to $200 billion annually.”  Those estimates are considerably different from the estimates prepared by the EPA, EIA and CBO that were issued in response to Congressional requests for cost estimates of the legislation while it was being debated in the House of Representatives.  The legislation is now being debated in the Senate, but the bill has been delayed by its sponsors for at least a month due to the ongoing health care debate.

At the time the Waxman-Markey bill was moving through the House, numerous studies were issued examining the legislation and attempting to quantify its cost to the economy.  Three studies – the Heritage Foundation, the Brookings Institute and the National Black Chamber of Commerce – all concluded that the bill would have devastating impacts.  The Heritage Foundation study concluded that over 2012-2035, there would be 2.5 million fewer jobs than without cap-and-trade, and the average annual lost national economic output would be $393 billion, hitting a high of $662 billion in 2035.  The Brookings Institute found a loss in personal consumption of $1-2 trillion in present value.  It also found that gross domestic product (GDP) would be 2.5% lower by 2050 while unemployment would be 0.5% higher, or 1.7 million fewer jobs.  The National Black Chamber of Commerce study said that GDP would be 1.3% ($350 billion) below the baseline economic projection in 2030 and there would be 2.3-2.7 million more unemployed in each year through 2030, even after accounting for “green job” creation.

On the other hand, the EPA said that the annual cost to the average American family would be $98-$140 annually in discounted terms.  It also said that due to new energy efficiency measures, consumer spending on energy bills would be about 7% lower in 2020 due to the legislation.  However, the EPA study was based on consumption changes, which typically are less than income changes as families respond to income changes by adjusting their savings.  The discount rate of 5% used by the EPA was much greater than any other climate-related economic study tending to reduce the estimated present value cost figure.  The EPA also assumed all the allowance proceeds would be remitted to consumers, which we now know is not part of the final bill.  Lastly, the EPA study assumed a doubling of nuclear power in this country.  When was the last time you heard this administration talk about boosting nuclear power as an energy policy solution, let alone seeking changes to the onerous regulatory process to secure and construct new nuclear plants?  Even if the government were to back nuclear plants, there would barely be any up and running by 2020, so there would be much greater costs imposed on the economy before any benefits come from new nuclear power plants.

The CBO study concluded that the legislation would cost $175 a year per household in 2020, with low-income households getting a benefit of $40 while higher-income households would incur a cost of $245.  The CBO study did not include the decrease in GDP resulting from the bill.  It is estimated that the GDP loss in 2020 would total $161 billion (in 2009 dollars).  The EIA study estimated the annual cost to American households at about $195, but it too failed to take into account the impact of the legislation on the economy and employment.  None of this mattered to New York Times columnist and Nobel Prize-winning economist Paul Krugman who embraced the government figures and downplayed the think-tank studies without ever acknowledging the important differences in their respective scopes.

If we assume there are approximately 100 million families, then the various studies would suggest total economic costs of roughly $10 billion to $18 billion a year from the cap-and-trade legislation.  This is in contrast to the Treasury Department memo suggesting $100-200 billion a year in government receipts.  Of course those estimates assumed all the allowance income would come into the government’s coffers. 

Other cost estimates and comments referring to “challenges” in the memos were redacted.  The CEI has sued to have this information disclosed.  If the federal government were run as a public company, the disclosed memos would be the equivalent of a “smoking gun” that is always sought out in shareholder lawsuits.  Knowing one thing and disclosing a materially different and benign cost estimate during the debate is frowned upon.  However, as we all know, all’s fair in love and war – and in economic debates, too!

Recent Oil Discoveries Gaining Media Attention (Top)

Last Thursday, The front page of The New York Times carried a story about the large number of new oil discoveries around the world.  It focused on the recent discovery by Anadarko Petroleum (APC-NYSE) off West Africa and BP’s (BP-NYSE) Gulf of Mexico find.  The point of the article was to suggest that the high oil prices of recent years had stimulated the oil and gas industry to step up exploration and the effort was beginning to pay off.  The article pointed out that during the first half of 2009 the industry had reported 200 meaningful discoveries of crude oil plus one huge natural gas discovery offshore Venezuela.  According to IHS CERA, the oil discoveries so far have totaled 10 billion barrels of new reserves.  At this pace, for all of 2009, the industry may discover 20 billion barrels, its best year since 2000.  That year the Kashagan field containing an estimated 20 billion barrels was discovered. 

Exhibit 17.  20-Billion Barrel Year Barely Helps Supply
Growing Gap (73K)

The article did make note of the fact that 20 billion barrels of new oil reserves still pales by comparison to the fields the industry discovered in the 1970s – Prudhoe Bay in Alaska, Ecofisk in the Norwegian sector of the North Sea and Cantarell offshore Mexico.  The chart above showing the history of oil discoveries since 1930 and highlighting some of the more famous fields discovered in history shows clearly that even a 20-billion barrel discovery year will do little to alter the challenge the industry faces in growing oil output to meet rising global oil demand.  This chart argues oil prices need to go higher.

Is The Recession Over? Drivers May Be The Key (Top)

The July data on vehicle miles traveled (VMT) in this country compiled by the Department of Transportation’s Federal Highway Agency has been released.  It showed that VMT have increased in three of the last four months.  This is a welcome change in direction that had been downward for the prior 16 months since the peak in driving in November 2007. 

Exhibit 18.  Vehicle Miles Traveled Now Trending Higher
Vehicle Miles Traveled Now Trending Higher
Source:  FHWA, PPHB

While VMT increased in July, average unleaded gasoline prices during the month fell from their June level.  How much did this help the continued rise in VMT?  In looking at the more recent monthly data, it is noticeable that the 12-month rolling cumulative total for VMT is now back to where it was in December 2008. 

Exhibit 19.  VMT Increase Despite 50% Higher Gasoline Prices
VMT Increase Despite 50% Higher Gasoline    Prices
Source:  FHWA, EIA, PPHB

Average unleaded gasoline prices for July were 84 cents ahead of their level for December 2008, or almost 50% higher (252.7 versus 168.7).  So despite the fact that July gasoline prices were lower than June by 10.4 cents or 4%, the fact they are substantially higher than six months ago as VMT have begun to rise has to be viewed positively.

Iran Political Tensions Revive Strait of Hormuz Focus (Top)

During last Friday’s G-20 press conference where the U.S., France and the U.K. announced previously undisclosed information they had presented to the International Atomic Energy Agency (IAEA) showing Iran building a second nuclear enrichment facility, we were reminded of events in the late 1970s when the Iranian revolution began.  At that time, every energy analyst had to become an instant expert on Middle East countries, religions, societies, politics and geography.  One aspect was to understand the importance of the Strait of Hormuz connecting the Persian Gulf with the Gulf of Oman.  It remains one of the world’s choke points for crude oil and other petroleum resource movements. 

According to the Energy Information Administration (EIA), an average of about 15 tankers a day move through the strait carrying 16.5-17.0 million barrels of oil.  The crude oil moving out of the Persian Gulf accounts for about 40% of waterborne oil trade and 20% of world oil movements.  There are some alternative routes for oil to exit the region, but they are more limited than the volume of oil moving now on ships, and would increase the length of time needed for oil to reach consumers.  (It shows the potential value of the U.S. strategic oil storage reserve.) 

Exhibit 20.  Strait of Hormuz One of World’s Oil Choke Points
Strait of Hormuz    One of World’s Oil Choke Points
Source:  EIA

The Strait of Hormuz is about 21 miles wide at its narrowest point and contains channels for in and out movement of ships, each two miles wide with two-mile wide buffer zones on each side.  The fear of the petroleum and shipping industries is that in a war or political confrontation, Iran would mine the strait or worse, sink ships to block the route.  Mines have been deployed before but they were removed

Exhibit 21.  Traffic Pattern Within The Strait of Hormuz
Traffic Pattern Within The Strait of Hormuz
Source:  Wikipedia

by navies before creating problems.  We are not suggesting this scenario will play out, but it is important to be aware of its potential.  The fact that crude oil prices did not spike higher on Friday after the disclosure suggests the oil market does not expect any military action in the immediate future.

Stock Buybacks Decline – Energy, Too (Top)

Floyd Norris of The New York Times authored a recent column re-examining a topic we have dealt with before – dividends and stock buybacks.  The column was based on Standard & Poor’s (S&P) latest quarterly data on corporate actions to return capital to shareholders.  The companies in the S&P 500 Index in the second quarter paid out $47.6 billion in dividends.  That was 8% below the amount paid in the first quarter of 2009 and 23% below those paid in the prior year quarter.  It was also the lowest quarterly figure for the index since the third quarter of 2004.

Corporate spending on stock repurchases was worse.  In the quarter, S&P 500 members spent $24.2 billion on buying back shares – 28% below the first quarter spending and down 72% from the same quarter in 2008.  The amount spent on buybacks was the lowest for any quarter since S&P began reporting the data in 1998.  The conclusion Mr. Norris comes to is that corporations love to buy back their shares when stock prices are high, but are reluctant or don’t have the financial resources to buy them back when the share price is low.  This would seem to put corporations in the camp of momentum investors rather than value investors.

A money manager who looked at the data suggested corporate stock buyback decisions are really liquidity-driven events.  When companies have lots of cash, i.e., balance sheets are very liquid, managers correct the situation by buying shares.  When they don’t have that extra liquidity, they stop share purchases.  In his view buyback decisions have nothing to do with whether managers or boards believe share prices are cheap or dear.  If true, then investors should stop evaluating company actions.

Mr. Norris said that a reason why investors viewed stock buybacks as a positive was that it indicated corporate managements and boards were confident that their share prices were undervalued and that the company would not need cash for a possible downturn in their business.  As he pointed out, that was not necessarily the case.  In the first quarter of 2007 when the first subprime lenders began to go broke, financial companies used almost $34 billion on share repurchases, the most ever for the sector.  This year this same industry spent less than $2 billion to repurchase shares during the first six months when share prices were cheap.  Further to that point, he cited American International Group (AIG-NYSE), which was the 21st largest spender on buybacks and the fourth largest in the financial sector during 2007, which spent $6 billion.  In the first quarter of 2008 it spent another $1 billion, only to be broke and dependent on a federal government bailout six months later.

Exhibit 22.  Is Buyback Spending Momentum Investing?
Is Buyback Spending Momentum Investing?
Source:  The New York Times

According to the data in the above chart, energy companies also followed the lead of the rest of corporate America.  The one difference is that energy has accounted for the largest share of corporate funds spent on buybacks so far this year, albeit a very small number.  Whether that trend will continue is anyone’s guess, but maybe energy company execs will prove smarter by buying when their share prices were lower.

Attacking Energy Subsidies Is Big Sport Now (Top)

President Obama’s rhetoric in recent days has focused on his desire to strip the U.S. energy business of its financial subsidies while giving more government funds to alternative energy sources.  A new study by the Environmental Law Institute and the Woodrow Wilson International Center for Scholars titled “Estimating U.S. Government Subsidies to Energy Sources: 2002-2008” examines the subject.  The study looked at both direct spending by the government and indirect subsidies through tax breaks.  It found that fossil fuels received total subsidies of $72.5 billion over the seven years, 2002-2008, while renewable fuels only were granted $29.0 billion.  If we average the subsidies, fossil fuel gets $10.4 billion a year compared to $4.1 billion for renewable fuels, a 2 ½ to 1 ratio.

Exhibit 23.  Dirty Fuels Subsidized More Than Green Ones
Dirty Fuels Subsidized More Than Green Ones
Source:  Environmental Law Institute

A blogger, David Roberts, writing on was all over this report and why the government needs to end fossil fuel subsidies.  We thought it interesting that fossil fuels were only receiving 71.4% of all the government subsidies for energy.  If you look at the distribution of energy consumption in this country by fuel type, traditional fossil fuels – oil, gas and coal – accounted for 85.6% of the nation’s energy supply in 2007.  If we include nuclear in the fossil fuel category, since it is not a renewable fuel, then the fossil fuel component of total energy consumption rises to 93.9%.  So on a contribution basis, fossil fuels are being discriminated against, not favored.

Exhibit 24.  Dirty Dwarfs Green Fuels Except In Subsidies
Dirty Dwarfs Green Fuels Except In    Subsidies
Source:  EIA, PPHB

An even more telling analysis is to examine the table of U.S. taxes other than income taxes paid by oil and gas companies prepared by the Energy Information Agency (EIA) from data it routinely collects from the energy companies in its Financial Reporting System.  Over the period 2001-2007, a similar seven-year period and almost a direct overlap with the period of the subsidy study, the oil and gas industry paid $64.3 billion in taxes other than excise taxes.  During that period, the industry also paid $346.2 billion in excise taxes, for a total tax bill of $410.5 billion.  And this doesn’t include any income taxes the oil and gas industry paid or the value of lease rentals and bonuses paid in offshore lease sales. 

Exhibit 25.  Oil & Gas Industry Taxes Swamp Subsidies
Oil      & Gas Industry     Taxes Swamp    Subsidies
Source:  EIA, PPHB

If we only look at the industry’s tax bill in 2007, taxes other than income and excise amounted to $60.3 billion, nearly as much as the seven-year tax subsidies.  The problem is that the contribution of the “old” energy sources – oil, gas, coal and nuclear – is not recognized by the public because its view of these industries is so negative.  Trying to change that image is a worthwhile endeavor, but an effort gaining little traction. 

Can You Believe Government Statistics? (Top)

We often find ourselves questioning government statistics, which makes us a big fan of John Williams’ Shadow Government Statistics newsletter.  He maintains a consumer price index (CPI) chart based on the original weighting of the index’s components that has shown a higher level of inflation in recent years than reported by the government using the newly balanced index.  But we were mystified by a report that pointed out how the Bureau of Labor Statistics, which prepares the CPI, is going to treat the “Cash-for-Clunkers” payments.  They are going to treat those payments as a reduction in the price of the purchased vehicle.  However, you may remember that the Internal Revenue Service is going to tax the payment as income to the recipient.  So how does the same payment get treated as income on one hand (boosts average annual incomes) and a price discount on the other (reduces the CPI)?  The net effect is to make government statistics appear better than they actually are.

With the end of the Cash-for-Clunkers program, automobile sales have plunged to an 8.8 million annual rate, the lowest annualized rate in years.  While GM is adding a third shift at one of its plants while talking positively about the outlook, Ford (F-NYSE) is touting its forecast that new car sales will be 14 million vehicles in two years.  Maybe this will happen.  If it does, then U.S. energy demand will rise – a welcome event!

Contact PPHB:
1900 St. James Place, Suite 125
Houston, Texas 77056
Main Tel:    (713) 621-8100
Main Fax:   (713) 621-8166

Parks Paton Hoepfl & Brown is an independent investment banking firm providing financial advisory services, including merger and acquisition and capital raising assistance, exclusively to clients in the energy service industry.

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