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Musings from the Oil Patch - December 8, 2009

Musings From the Oil Patch
December 8, 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

Debate Over Climategate Raises Global Temperatures (Top)

The hacking of the computer serving the University of East Anglia’s Climatic Research Unit (CRU), the epicenter of global climate change research, has contributed to rising temperatures as climate change proponents and its deniers battle over the significance of the emails suddenly made available to the public.  One issue is who did the hacking and was it done in anticipation of finding incriminating material that would cloud the climate change effort right at the start of the UN Framework Conference on Climate Change in Copenhagen? 

As we suggested in our last Musings, this episode has stirred up considerable controversy about the efficacy of the core of climate change research.  This controversy is not unexpected in light of the purloining of emails and research data barely three weeks before the start of the UN global warming conference, or COP15 as it is being called.  The supporters of the climate change orthodoxy suggest the content of the emails, while somewhat unseemly, merely reflects the normal discourse among academics intent in advocating for their stated positions.  As a professor of economics at Princeton University, The New York Times columnist and ABC Sunday talk show participant, Paul Krugman, said there was “no smoking gun” contained in the emails.  To the contrary claim global warming doubters who point to email exchanges showing concerted and supposedly coordinated efforts to prevent the publication of scientific data and analyses that challenge the global warming orthodoxy.

One of the more interesting aspects of the climate change furor, in light of the email release, was the recent determination by a British court that climate change orthodoxy is equivalent to religious beliefs. 

In a case involving the termination of an employee who claimed that his strong moral beliefs about global warming forced him to live his life in a certain way that clashed with the demands of his job, the role of global warming orthodoxy was at issue.  The employee was terminated for his inability to fulfill his job responsibilities according to his employer.  Justice Burton of the British court stated, “A belief in man-made climate change and the alleged moral imperatives is capable, if genuinely held, of being a philosophical belief for the purpose of the 2003 Religion and Beliefs Regulations.”  Some climate change critics would suggest that this is what global warming science has become – a religion.  That means it has become faith-based and immune from debate and scientific analysis, at least as practiced by the scientists whose emails were hacked.

In the past two weeks it has been interesting to see the debate over the emails – and to understand their scope.  The further highlighting of the issue by revelation of the destruction of the original temperature data underlying the climate analysis work due to computer storage capacity issues in the 1980s has increased the concern over the integrity of the body of global warming research.  If the raw data is gone and we are only left with “homogenized” data then how can any future research validate the past work without creating skepticism of the conclusions? 

A column by John Tierney in The New York Times discusses the peril of trying to spin global warming science.  He quoted extensively from an email from a computer expert discussing his struggle to make sense of a database of historical temperatures.  While making much of the angst of this expert, the text of one email goes on to say, “It’s Sunday evening, I’ve worked all weekend, and just when I thought it was done I’m hitting yet another problem that’s based on the hopeless state of our databases.  There is no uniform data integrity…” 

Much of the temperature data comes not from actual thermometer measurements, but rather from analyses of tree rings and other proxy data such as ice cores and lake sediments.  These indirect measurements show that temperatures declined in the middle of the 19th century and then rose in the first half of the 20th.  This pattern concurs with other temperature-related data.  The tree-ring data, however, doesn’t show that sharp rise in temperatures.  In fact, it shows a sharp decrease in temperatures, which contradicts what has been measured directly with thermometers. 

Because of this data conflict, Dr. Phil Jones, the head of the CRU, removed the later tree-rig temperature derived data and replaced it with direct thermometer readings when preparing the temperature graph that was used for the cover of the 1999 report of the World Meteorological Organization and was designed to show that temperatures in the past several decades were the warmest in the past millennium.  No one was ever told of this data shift and the line on the graph suggests one continuous data source.  The shift in data is done so well that only a blown-up chart shows the termination of one data source and the start of another.  As Mr. Tierney suggests, the story behind the graph doesn’t show that global warming was a hoax or a fraud, but it does illustrate that the evidence of global warming is not unequivocal as many climate scientists claim.

Mr. Tierney points out that in 2004 a skeptic had raised a question about the tree-ring data on RealClimate, a blog operated by climate scientists.  In response, Michael Mann, a climate professor at Pennsylvania State University (PSU) and the creator of the “hockey stick” temperature graph that has since been discredited, responded:

“No researchers in this field have ever, to our knowledge, ‘grafted the thermometer record onto’ any reconstruction.  It is somewhat disappointing to find this specious claim (which we usually find originating from industry-funded climate disinformation Web sites) appearing in this forum.” 

Mr. Tierney goes on in his column to say, “Dr. Mann now tells me that he was unaware, when he wrote the response, that such grafting had in fact been done in the earlier cover chart, and I take him at his word.  But I don’t see why the question was dismissed so readily, with the implication that only a tool of the fossil-fuel industry would raise it.”  Mr. Tierney’s statement is correct, but Dr. Mann’s original response was reflective of the religious orthodoxy of climate change that has been behind this movement.  We recently read where PSU is going to investigate Dr. Mann as a result of the new revelation in these emails after having once exonerated his academic work.  Dr. Jones at the CRU has temporarily stepped down while the university investigates.  Dr. Jones also canceled his speech at the Copenhagen conference raising even more questions.

We have been following the disclosures of the emails (including reading many of them) and the debate over their significance closely.  We found it interesting that part of the email discussion was how to avoid the release of data under the U.S. Freedom of Information (FOI) requests and the comment from one of the leading British climate researchers to keep secret that the UK also has a FOI law.  By working diligently to prevent disclosure of data and computer codes that underlie the climate models producing the cataclysmic forecasts, these scientists have done great harm to their efforts.  Many of the critics of global warming research have questioned the science all along, but have been willing to acknowledge that there are legitimate concerns and unknowns about our climate that need further research.  What is evident from the emails is that to this group of scientists, and supposedly many of their fellow travelers, debate, investigation and skepticism of extreme solutions for global warming was not going to be allowed.  Thus, the effort to stifle the debate took on the highest priority.  As is becoming increasingly evident, the root cause of this effort to stifle criticism is money. 

Irwin Seltzer, director of economic policy at the Hudson Institute, writing in The Weekly Standard about the upcoming Copenhagen climate change conference, points out that prudence dictates the nations of the world take steps to reduce CO2 emission.  He views potential solutions that have “low-probability risks with high-magnitude consequences” as worthy of consideration.  But he is worried about the UN effort, which at the moment has a support staff of 200 and a $30 million annual budget.  He points to an editorial in London’s The Times that stated, “Copenhagen is perhaps viewed best as…an agreement that, if successful, could define the global industrial and commercial landscape of the 21st century.”  Mr. Selzer believes the UN is eager to provide that definition, acquire the power to tax to fund its vision and to take whatever steps are necessary to enforce the agreed emission-reduction targets at the conference. 

Even without that scenario, research spending on climate change science has been believed to be a driving force behind the movement.  This money partially explains why the scientists have been so keen to make the worst computer model outcomes appear to be the expected outcomes society will face without enacting the draconian carbon-control measures recommended.  As Tom Allen, CEO of Satellite Observing Systems, put it in a letter to the editors of the Financial Times recently, “Anyway, who determines that any change in our climate will be bad?”  He raised this point after presenting a number of specific climate-related measurements that call into question the environmental damage the planet has supposedly suffered in recent years.  He concluded by saying “The time has come for a more open debate on what may (or may not be) cause the modest changes we witness in our climate – or must we wait for another 10 years of cooling?  The issue is far from ‘settled’.”

Bret Stephens of The Wall Street Journal pointed out that Dr. Jones was the recipient or co-recipient of $19 million worth of climate change research grants between 2000 and 2006, a six-fold increase over the money he received in the 1990s.  Mr. Stephens asks why the sudden increase in money for research?  Well, it was all due the vigor of ringing the climate peril bell.  Now, the most recent European Commission’s appropriation for climate research comes to nearly $3 billion.  That ignores money that comes from member governments.  In the U.S., the House of Representatives bill for climate research by the National Atmospheric and Space Administration (NASA) is $1.3 billion.  The government also plans on spending $400 million for the National Oceanic and Atmospheric Administration (NOAA) and $300 million for the National Science Foundation.  Even some states have gotten into the climate research program as California is scheduled to spend $600 million on that effort.  Australia and the UK have government departments focused on climate change.  With money for climate research flowing like water due to the consensus of the climatic catastrophe awaiting the planet if actions to control carbon emissions are not undertaken, it is not a huge secret that disaster scenarios will be popularized.  Just as horror flicks bring Hollywood untold millions, climate change fears bring rewards for academics and researchers. 

Electric Vehicles Are In Our Future – A Good Or Bad Thing? (Top)

Recently, a newly organized industrial lobby, Electrification Coalition, released a policy paper titled, Electrification Roadmap, Revolutionizing Transportation and Achieving Energy Security that is designed to promote the growth of electric vehicles in this country.  The coalition describes itself in the following way: Nonpartisan, not-for-profit group of business leaders committed to promoting policies and actions that facilitate the deployment of electric vehicles on a mass scale in order to combat the economic, environmental and national security dangers caused by our nation’s dependence on petroleum.  The coalition’s members include executives from AeroVironment (AVAV-OTC), NRG Energy (NRG-NYSE), Nissan (NSANY.PK), Johnson Controls (JCI-NYSE), FedEx (FDX-NYSE) and A202 Systems (AONE-OTC) along with executives from several small, private companies.  Their basic pitch is that the economic, technical and practical challenges associated with a transition to plug-in hybrid electric vehicles (PHEVs) and electric vehicles (EVs), which are being designated as “grid enabled vehicles” (GEVs), are insurmountable in a free market economy.  The coalition has, as its driving force, the desire to influence public policy in an effort to upgrade the nation’s electricity grid and to promote increased use of electricity through efforts such as increasing the fleet of electric vehicles.

Public policy involving greater use of EVs is also being developed in tiny Denmark, the site of the UN global climate summit this week, home to 5.5 million people and 497 registered EVs.  The largest power company in Denmark, Dong, has teamed up with the Silicon Valley EV start-up, Better Place, in a $100 million effort to wire the country with charging stations and to build service stations where EV batteries can be swapped out of vehicles rapidly.  This latter effort is important if EVs are to gain market share as their range is limited to about 100 miles on a single charge and recharging normally requires about five hours.  Dong is also intent on using wind power, which already supplies about 20% of the nation’s power, to fuel the expanded electricity grid to further help reduce the country’s carbon emissions.  So far, the companies’ efforts have been less than spectacular. 

In January of this year, Shai Agassi, the founder of Better Place, said his company would have 100,000 charging spots in place and several thousand EV cars on the road in Denmark by 2010.  As the deadline approaches, there are no Better Place EVs on the road and only 55 charging spots in operations.  Mr. Agassi says the target date for these goals was always 2011 and that the company is well on its way to meeting its goals.  Mr. Agassi and Better Place was the subject of a long article in The New York Times Magazine last April where his progress in executing in Israel the sort of plan he envisions for Denmark appears to be more successful.  The article describes the travels of a journalist with Mr. Agassi around the country using charging spots for quick refueling and a service station to change out the car’s battery on a longer journey.  The key to Better Place’s success is not only having the charging and battery changing infrastructure in place, but also having an interactive global positioning system (GPS) that enables the company’s software to know where an EV is located and what its battery charge level is so it can direct the driver to the nearest charging spot or service station, depending on the driver’s travel needs. 

Another major challenge for Better Place is how to deal with battery configurations of different vehicles.  The concept is for drivers to purchase their EV and rent the battery from Better Place paying a mileage use charge and a fuel fee.  To improve the efficiency (and profitability since the service stations are estimated to cost $1 million in Denmark) of the service stations, Better Place is hoping for a degree of battery standardization among vehicle manufacturers in order to reduce the number of different batteries it must stock.  Also, there needs to be standardization in the mechanism holding the battery in place in the various vehicles to enable Better Place to utilize its robot battery changers more effectively.  Better Place’s target is to have the fully automated battery change-out process take no more time than that normally required to fill a vehicle’s gasoline tank.  For the EVs Better Place is building in Israel, the battery is held in place with a release mechanism used to hold bombs in military fighter jets. 

The success of Dong’s and Better Place’s efforts will depend on getting more EV manufacturers to commit to supplying vehicles to the country.  So far only Renault Nissan has agreed to supply EVs that work with Better Place’s robots.  A spokesman for Toyota (TM-NYSE), one of the world’s largest hybrid vehicle manufacturers, says that it “sees no clear business advantage for us with Better Place.” 

For the EV and electrification effort to succeed in Denmark there is also the issue of vehicle cost.  The country levies a tax of 200% on new cars.  A vehicle that costs $20,000 in the United States would cost $60,000 in Denmark.  For 25 years EVs have been exempt from that tax, but the EV models available have had very limited capabilities and obviously limited consumer appeal.  The Danish government is proposing a $40,000 per EV tax break along with free parking in Copenhagen, a city where 37% of the travel is by bicycle and parking spaces are reduced every year.  Will an advanced-market EV from Renault Nissan and practical and readily available charging options prove sufficient for the tax break to stimulate a shift in consumer attitudes toward vehicle purchases?  The big experiment is about to begin.

But should consumers really be considering GEVs?  Are they the right solution for the U.S. energy and emission challenges?  According to lawyer, investor and former battery company executive, John Petersen, the answer is an emphatic “No!”  His latest critique of the economics of EVs was written in response to the growing chorus of adoring Wall Street analysts.  He recently read a report from the latest champion of EVs, Steve Milunovich of Bank of America Merrill Lynch (BOA-NYSE).  The report was titled Ending the ICE Age and focuses on the future of the PHEVs.  Mr. Petersen commented that this was the third glowing report about the future of GEVs issued by Wall Street firms since October that he had read.  According to him, they all cite the fuel savings and CO2 reduction potential of GEVs as the driving force behind their eventual success. 

The reports all assume that battery technology will cause prices to drop from current levels of roughly $1,200 per kilowatt (kWh) to something on the order of $500 per kWh over the next five to ten years.  While all the reports warn that the promise of GEVs will not be realized unless lithium-ion battery developers can deliver on their promises to make cheap, powerful, durable and safe products.  Mr. Petersen’s question about these reports is why their authors never address the question of whether the fundamental premise underlying GEVs is correct.

To answer the question, Mr. Petersen prepared a spreadsheet comparing the various alternative vehicle types along with the economic impact of a hypothetical $500 million plant dedicated 100% to making either Leaf class BEVs, Volt class PHEVs or Prius class HEVs.  The column containing information about conventional internal combustion engine cars (ICE) is there to provide a baseline comparison against the various GEVs.  To prepare the analysis, Mr. Petersen made the following assumptions about the vehicles: batteries cost $500 per kWh; every vehicle will travel 12,000 miles per year; every GEV will get four miles of electric-only range for each kWh of charge; and all GEVs will use electricity from utilities that emit the national average of 585 grams of CO2 per kWh. 

Exhibit 1.  Are EVs A Smart Move For America?
Are EVs A Smart Move For America?
Source:  John Petersen, Seeking Alpha, PPHB

As Mr. Petersen points out, the economic comparison is very attractive between HEVs and conventional ICE vehicles.  He suggests that not only would the economic comparison improve but the carbon footprint for vehicles would be nearly completely eliminated if conventional HEVs utilized compressed natural gas (CNG) as its substitute fuel.  Mr. Petersen admits this would require a significant commitment as there will be the time required and the cost to develop a retail network of CNG distribution outlets.  He believes, however, that given the well-developed network of natural gas pipelines crisscrossing the United States, the CNG fueling infrastructure could be created in a relatively short time span. 

What Mr. Petersen also believes is that it makes no sense for the government to push for GEVs as their economics are terrible compared to those of HEVs such as the Toyota Prius.  The environmental and economic cost of building Chevrolet Volts or Chrysler Leafs pale in comparison to the huge number of Prius vehicles that could be built with the same investment. 

What we know, however, is that GEVs represent the government’s “technology du jour” solution for our energy and emissions problems.  This country has been dealing with “new technology solutions” for addressing America’s energy and emission shortcomings for many years as demonstrated by the list of past technology solutions previously touted as government solutions.  At this point in time we have no idea what will be the next vehicle power source trotted out as the “silver bullet” solution, but we hasten to add that we fully expect there to be another.

Exhibit 2.  Many Failed Power Solutions
any Failed Power Solutions
Source:  Seeking Alpha, PPHB

These attempts to find silver bullet-solutions for our energy problems are also mirrored in the hype associated with the current popular solution of GEVs.  One can hardly pick up a newspaper or mainstream news magazine without reading about the glorious promise of GEVs to solve all our energy problems while at the same time reducing the nation’s carbon emissions and creating millions of “green jobs.”  The following chart on the hype-cycle of emerging technology initially created by the technology research and consulting firm, Gartner Group, was adopted by TIAX LLC and presented at a 2008 conference on plug-in hybrid vehicle technology.  TIAX said at the conference in May 2008 that it felt PHEVs were approaching their peak visibility.  Based on the current media hype and our government’s leaders’ current infatuation with GEVs, it would seem that assessment was premature. 

Exhibit 3.  GEVs Regarded By Government As Best Solution
GEVs Regarded By Government As Best    Solution
Source:  John Petersen, Seeking Alpha

Part of the hype surrounding GEVs is associated with the government’s desire to promote a clean-energy solution to the nation’s energy shortage and carbon emissions challenges.  It also fits with the religious orthodoxy surrounding the current administration’s energy policy.  It is why our Secretary of Energy can say that he’s agnostic about natural gas.  It is why our Secretary of the Interior can promote offshore East Coast wind power as a potential source for all the nation’s power needs while ignoring the tens of thousands of wind turbines that would require.  This orthodoxy also explains why the waters off California and Florida along with large swaths of Alaska have become hostages to the green-energy movement.  At the end of the day, technology has yet to develop an alternative to the ICE that is as efficient in delivering power and as flexible in its application.  There may actually be significant room for improvement of the ICE – possibly with the adoption of diesel technology – that will enable the U.S. to address its oil consumption and carbon emissions goals without trying to revamp the nation’s entire transportation infrastructure. 

It would actually seem, based on an assessment of the future trend of power-train use worldwide that the ICE and HEV technologies will continue to rule the motor highways of the globe.  This forecast comes despite the recent report by Britain’s Climate Change Committee that the nation needs to establish a national charging system to support 240,000 EVs on the road by 2015 rising to 1.7 million by 2020.  As Roland Berger Strategy Consultants put forth during a presentation at last fall’s Frankfurt Auto Show, the market penetration rates of automotive power train technologies in 2020 still support ICE and HEVs overwhelmingly. 

Exhibit 4.  Market Penetration Of Power-Train Technologies
Market Penetration Of Power-Train    Technologies
Source:  Roland Berger Strategy Consultants, Seeking Alpha, PPHB

If Mr. Petersen and the Roland Berger Strategy Consultants are correct, the world should narrow its focus on vehicle power-train technologies to ICE and HEVs.  Both power trains leave room for improved efficiency that would address reducing the nation’s oil import bills and lowering our carbon emissions.  Sounds like a good plan, although it is probably one our government will not embrace, just as they distain doing anything to help the domestic oil and gas industry. 

Gas Production Continues To Outrun Demand Hitting Prices (Top)

The latest data on natural gas production in the United States reported by the Energy Information Administration (EIA) shows little erosion in supply as a result of the sharp drop in gas-directed drilling that commenced at the start of this year.  The lack of progress in curtailing gas production coupled with falling demand contributed to downward pressure on prices – both for near term spot and futures prices – for much of 2009.  After natural gas futures hit a low of $3 per thousand cubic feet (Mcf) at the beginning of September, prices rallied driven by the prospect of increased gas consumption due to winter demand.  Gas traders also started covering their futures’ contract short positions as there was a growing conviction that gas production would imminently begin falling easing the gas supply/demand imbalance.  In about a three week span during September, gas prices climbed from the year low to $5/Mcf.  Since then they have fluctuated between $4.50 and slightly over $5/Mcf. 

Exhibit 5.  Gas Futures Prices Have Climbed In Recent Months
Gas Futures Prices Have Climbed In Recent    Months
Source:  EIA, PPHB
Commencing in 2005, natural gas production in the Lower 48 states started growing.  Initially the growth was obscured by the hurricane impacts on gas production in the Gulf of Mexico.  But as shown by the data for onshore gas production, growth began in the latter part of 2005 driven by the first measurable amounts of gas shale production coming largely from the central Texas Barnett region.  As can be seen, the growth of unconventional gas production boosted the onshore production volumes throughout 2006, but in 2007 the pace of unconventional gas production accelerated.  It continued to grow at a rapid rate through late 2008 following the height of the credit market crisis.  After Hurricane Ike’s impact on Gulf of Mexico production in the fall of 2008, gas production growth flattened out.  The slowing in production growth was largely associated with the fallout from the credit crisis and the growing economic recession. 

Exhibit 6.  Gas Production Sustained Despite Rig Drop
Gas Production Sustained Despite Rig Drop
Source:  EIA, Baker Hughes, PPHB

Since the gas-directed rig count peaked in the summer of 2008 and then subsequently collapsed at the start of 2009, petroleum industry professionals and investment analysts have been speculating on which month natural gas production would enter a freefall.  While the forecasters had acknowledged the influence the highly prolific U.S. unconventional gas-shale plays were having on production growth, they did not appreciate how these wells were really changing the North American gas industry.  The historical relationships between gas well drilling and natural gas production no longer appeared to be of any help in forecasting the industry’s projected supply growth.  From forecasting the downturn impact from the fall in gas drilling, the current industry focus has shifted to worrying about how to create new markets for the seemingly endless supply of new gas.

Throughout most of the last 50 years of U.S. natural gas industry history, producers have worried about developing adequate supplies to meet apparent relentless demand growth.  During this period, growth in gas demand was due to the fuel’s cleaner burning characteristics and the fact it was a cheap energy source.  Throughout much of this historical period, natural gas consistently took market share from crude oil and coal. 

During the golden age of natural gas from the mid 1950s through the 1990s, the challenge for the producing industry was in dealing with federal government regulation that priced gas based on a rate of return calculation for its primary consumer – the utilities.  Regulation became the preferred way to control supplies when customers and the government thought gas shortages presented serious economic risks.   The federal government at one point determined due to limited natural gas supplies, it should restrict consumption to only those uses that produced the highest economic value – pharmaceuticals and chemicals.  There always was a high level of concern about natural gas as a heating and cooking fuel. 

Regulation had the effect of eliminating natural gas industry marketing.  The recent surge in gas production, coupled with the prospect that the nation has potentially 100 years of economically available gas resources, has created a significant need for new approaches to creating new gas consuming markets.  This demand-building exercise was behind the stepped-up marketing pitches of industry leaders Boone Pickens and Aubrey McClendon.  These advocates for increased natural gas consumption grabbed on to the growing global warming movement to push for increased use of gas as a cleaner burning transportation fuel.  This move appeared attractive as vehicle fuels were identified as a major source of carbon emissions that in turn were linked to climate change.  This push to develop new natural gas consumers has been hurt by the economic recession and its impact on natural gas consumption by its traditional consumers. 

Exhibit 7.  Domestic Gas Consumption Flat In Recent Years
Domestic Gas Consumption Flat In Recent    Years
Source:  EIA, PPHB

We started looking at the history of U.S. natural gas demand growth in light of the sustained production growth phenomenon the industry is currently experiencing.  As can be observed when looking at natural gas consumption since 1949, it peaked in the early 1970s and then fell in a step function until it bottomed in 1987.  Consumption then began rising again steadily through the 1990s as cheap gas gained market share, especially in the electric power sector.  Gas-fired turbines and combined-cycle power plants were favored by electric utilities because they were less expensive to build, could be built quicker and were cleaner burning.  Since the recessionary years of 1998-1999, natural gas consumption has been relatively flat although experiencing some volatility. 

In light of the flat gas consumption pattern of the past few years, we began wondering what it will take to grow consumption if gas producers continue to drill and produce because they believe their actions are profitable.  Producers say that the prolific nature of the gas-shale reserves contributes to them being economic at relatively low finding and development (F&D) costs per thousand cubic feet of gas production.  This may be true while producers are drilling the sweet spots in these gas shale formations, as they move into less prolific areas of the formations we expect F&D costs to rise, and possibly significantly.  Additionally, producers have benefited from the recession’s impact on oilfield service industry prices.  Now, however, service companies are starting to demand higher prices to provide the products and services they have offered at much lower prices in recent months.  As oilfield service costs rise in 2010 and thereafter, coupled with less productive wells, we can expect sharply higher F&D costs.  Will all the current “star” gas-shale formations remain so in the future?  That remains to be seen.

Possibly the greater challenge for the natural gas market is the issue of demand.  While Mr. Pickens and Mr. McClendon attempt to create new markets (in particular the transportation fuel market) for natural gas, we were intrigued with forecasts from the EIA about gas demand in the next few years among the industry’s traditional gas customers.  In the accompanying exhibit we have plotted the annual increase in the volume of natural gas consumed in the United States since 1989 along with the EIA’s forecast for 2009 and 2010.  During the past two decades, there were only five years in which natural gas consumption declined.  It fell in 2005 and 2006 and is predicted by the EIA to fall again in the 2009 and 2010 period.  The recent natural gas demand performance and the expectations for this year and next highlight challenges the industry faces in stimulating demand growth.

According to the forecast contained in the EIA’s reference case adjusted for the enactment of the Obama administration’s economic stimulus bill earlier this year, total natural gas demand in this country is projected to fall steadily from 2008 until 2014.  The total consumption decline over this period is projected to be two trillion cubic feet (Tcf).  The future is very challenging as it is not until 2023 that total gas consumption is forecast to return to the demand level

Exhibit 8.  Annual Gas Demand Set To Fall This Year And Next
Annual Gas Demand Set To Fall This Year And    Next
Source:  EIA, PPHB

experienced in 2008.  That means the gas industry can look forward to nine years of very slow demand growth once the consumption contraction ends in 2014. 

Exhibit 9.  Sector Demand Points Up Power Industry Problems
Sector Demand Points Up Power Industry    Problems
Source:  EIA, PPHB

When we look at the EIA’s gas demand forecast by sector we find that residential consumption climbs in 2010, reflecting the government’s expectation of a cold winter, but then falls in each of the following two years.  Commercial demand rises to its highest level of the entire seven year period, but then falls in 2011 and remains flat in 2012.  Industrial demand falls in 2010 by an amount equal to its contraction in 2009.  It starts to recover in 2011 and continues to climb in 2012.  The electric power sector is the surprise with consumption falling every year from its peak in 2007.  Lastly, the transportation sector, which has been the focus of much attention and hype, is essentially negligible in the forecast period. 

This would suggest that the federal government doesn’t see much traction in the industry’s effort to get more compressed natural gas cars and trucks on the highways, and if it did, it would take a long time to impact total demand.

Exhibit 10.  Federal Reserve Sees Wide Range Of Outlooks
Federal Reserve Sees Wide Range Of Outlooks
Source:  Gluskin Sheff

Stimulating natural gas demand growth is going to depend on a robust economic recovery.  Economic data released over the past month continues to show a mixed picture for the economic recovery.  The most recently released notes from the Federal Reserve Bank shows a wide range of forecasts for the nation’s economic outlook.  Until the economic growth projections increase, it appears that domestic energy markets and natural gas in particular, will be challenged to grow meaningfully.  That means gas producers will need to either rein in their drilling and completion spending or have existing production drop precipitously over the next 12 months.  Either scenario will have a dramatic impact on oilfield activity.

Oil Demand Projections Depend On Developing Economies (Top)

There has been considerable interest generated in the recently revised oil demand growth forecasts of the International Energy Agency (IEA) along with those of the Energy Information Administration (EIA) and Organization of Petroleum Exporting Countries (OPEC).  All of these organizations’ demand revisions are based on the belief that global economic activity will continue to recover in 2010 boosting the need for more oil consumption.  Enthusiasm about the improving health of the global economy is predicated on the credit crisis being sufficiently resolved that financial markets are capable of financing world trade and investment in new infrastructure. 

The early IEA oil demand forecast has been increased slightly in each of the past two months and now calls for a 1.3 million barrel per day (mmb/d) increase next year.  As shown in the accompanying exhibit, that annual oil demand growth projection is meaningfully above the 20-year average demand growth record of 1.0 mmb/d.  The 2010 demand forecast is even approaching the 1.45 mmb/d annual average growth achieved during the decade of 1994-2004.  As we have seen in previous early IEA forecasts, they are often wrong about how the following year will unfold.  The graph shows in the light blue columns the first IEA forecasts for 2005, 2006 and 2007 along with the actual consumption record (light brown columns).  In every year, the actual result was a fraction of the demand growth forecast initially. 

We also show in green the early forecast for 2008 (first green column) that called for over 2 mmb/d growth while the reality was that actual demand contracted for the year due to the emerging recession and the credit crisis.  A similar pattern holds for 2009.  Initially, oil demand growth was forecast to grow by nearly 900,000 barrels per day (first brown column) while the latest demand estimate is for a loss of 1.5 mmb/d.  Given this forecasting record, we remain cautious about accepting the IEA’s current demand growth projection for 2010. 

Exhibit 11.  IEA’s Forecast Record Doesn’t Create Confidence
IEA’s Forecast Record Doesn’t Create    Confidence
Source:  IEA, PPHB

The key to the IEA’s forecast is its belief that oil demand growth in developing economies will be so strong that it will overwhelm the agency’s estimate of declining consumption in developing economies.  In 2007, before the recession hit, oil consumption in the OECD countries accounted for almost 57% of global oil use.  This year that percentage has fallen to 53.7% and is projected by the IEA to further decline to 52.8% next year.  According to the IEA’s World Oil 2009 report, it expects oil consumption in developed economies to continue to decline for the next 20 years with world use to rise about 1% per year entirely based on the growth of developing economies and their rising lifestyles.

Exhibit 12.  IEA Sees Oil Demand From Developing Economies
IEA Sees Oil Demand From Developing    Economies
Source:  IEA

One of the challenging issues for this forecast is the Chinese data on car sales versus petroleum demand.  Why is petroleum demand in China not rising in step with increased car sales?  The recent issue of The Economist explored the issue of whether there is something wrong with the data or if Chinese auto sales are not real sales.  There is a school of thought saying that the Chinese government’s stimulus program, which involved reducing the high tax on small-engine cars, has provided an incentive for consumers to buy cars, but then they are electing not to drive them much.  The Chinese banks also have been encouraged to make consumer loans to finance car sales.  At the same time, to curb petroleum inputs, the Chinese government has raised prices for petroleum products making gasoline more expensive.  If Chinese car sale data is sending false signals about petroleum demand in the country, could the IEA’s forecasting of global demand growth be overstated?  It was the IEA’s failed forecasting model for China’s demand growth in 2004 that led to the agency being so wide of the mark that year and sending signals to the oil market that global demand was rapidly accelerating.  As we know, 2004’s annual demand growth, especially as it was driven by Chinese oil consumption appears to have been an aberration and not the start of a new growth rate for world petroleum.

Regardless of the pace of world oil demand growth, the major challenge for the petroleum industry is to find and develop new sources of supply.  As the IEA forecasts, crude oil from currently producing fields will only account for about a third of current production due to aging producing fields and their accelerating decline rate.  Another significant development is that natural gas liquids will more than double its contribution to global supply and unconventional oil supplies will be three to four times their 2008 contribution.  Unconventional oil is defined as not only heavy oils,

Exhibit 13.  Chinese Auto Data Raises Questions
Chinese Auto Data Raises Questions
Source:  The Economist

but also oil sands and oil shales along with deepwater oil production.  The single defining characteristic of this oil supply is its high cost to bring to the market.  Lastly, the petroleum industry will be challenged to find a huge volume of production from fields not yet developed or, in some cases, not yet found.  All of this suggests that future oil costs will be rising and the effort to bring these resources to market will be oilfield service intensive.

Exhibit 14.  World Needs To Find Significant New Oil Supplies
World Needs To Find Significant New Oil    Supplies
Source:  IEA

The oil world of the next several decades will be one that will be challenged even given the current surplus oil productive capacity and large volumes of oil inventories.  As has been a major challenge for the global oil industry at various points in time in the past, oil demand will be the key variable to watch.  The prospect of 20 years of declining demand in developing economies and the growing use of renewable and other clean fuel sources signal that oil consumption growth will be challenged to rise at a rate in excess of the IEA’s forecasted rate of 1% per year.  This is another reason why we question the current IEA oil demand forecast for 2010.

International Drilling Rig Market Hit By Recession Trends (Top)

We are all familiar with the collapse in the U.S. rig count starting at mid-year 2008 due to the impact of the emerging recession and the growing credit crisis.  Since hitting bottom last summer, the rig count has climbed, largely driven by increased drilling for oil although there has been about a 10% increase in gas-focused drilling despite the huge gas inventories.  We have always thought that the best comparison of the current rig downturn was the experience of the industry in the period from 1973-1983.  We have shown the absolute rig count performance for the 1973-1983 period compared to 2000-2009 year to date.  The chart shows how similar the shape of this downturn is to that historical period although the magnitude of the rig fleet size is not as large as during the 1970s and 1980s.

Exhibit 15.  Rig Count Downturn Mirrors 1970s Correction
Rig Count Downturn Mirrors 1970s Correction
Source:  Baker Hughes, PPHB

As we learned in looking at the raw rig data for these two periods, by indexing each to 100, it was easier to compare and contrast the current rig downturn to the 1973-1983 downturn.  Also, with indexed data it becomes easier to develop a forecast of the future rig count based on past rig count trends.  The indexed rig data shows that in this drilling cycle, we never employed as many rigs at the peak as in the earlier cycle peak.  The current correction was equally as bad as in the big industry drilling collapse, but it happened in less time.  The speed of this collapse is what has surprised most industry participants and analysts.

Exhibit 16.  Indexed Rig Count Shows Speed Of This Correction
Indexed Rig Count Shows Speed Of This    Correction
Source:  Baker Hughes, PPHB

The upturn in the current rig count has also come slightly quicker than the first upturn in the 1980s period, but the shape of this rig upturn looks more like that experienced in the sustained upturn of 1983.  As we know, the collapse in crude oil prices in 1985 ultimately led to the collapse in drilling and the drilling industry, so the 1983 upturn actually reflected an un-sustained recovery.  It is hard to see that this scenario will repeat, but without a sustained recovery in oil and gas prices, there could be a relapse in drilling at some point in the future. 

The big question is whether we can learn anything about the future of the international rig count from the domestic rig count pattern.  The major difference between the international and domestic rig count is the mix of rigs.  The offshore rig fleet component is much larger than in the domestic count.  Offshore drilling and development work tends to be much more long-term oriented so it is less subject to quick adjustments due to changes in oil and gas prices.  That is not true for land drilling although international land drilling tends to be more stable than domestic land drilling due to the lack of oilfield infrastructure in many foreign countries.

Exhibit 17.  Offshore Large Component Of International Count
Offshore Large Component Of International    Count
Source:  Baker Hughes, PPHB

The difference in drilling rig trends over time is best observed in the accompanying chart.  In order to study how the current international drilling industry correction compares to the 1982-1987 downturn we plotted them in the next chart.  While the current international rig count grew in the first year of the comparison period, the pace of the downturn seems to be following that of the past until recent months.  The current rig count upturn appears to be sending an optimistic note to the industry.

Exhibit 18.  Current Rig Count Follows 1980s Contraction
Current Rig Count Follows 1980s Contraction
Source:  Baker Hughes, PPHB

What we see when we examine the performance of the current land rig downturn is that this segment of the rig fleet has done much better than we might have expected.  This is especially true given the most recent upturn in drilling activity.

Exhibit 19.  Land Rig Downturn Better Than 1980s Correction
Land Rig Downturn Better Than 1980s    Correction
Source:  Baker Hughes, PPHB

On the other hand, the current offshore drilling rig performance has not done as well as in the 1980s.  While the offshore rig count has underperformed the past cycle, the fact that the current rig count is generally on track with the past is encouraging.  If the current rig count continues to follow the past cycle’s performance, then we can expect offshore rig activity to stabilize and eventually begin to rise.  The long-term $64-question is whether there will be an industry event that might undercut the profitability of any offshore drilling as occurred in the mid 1980s with the collapse of global crude oil prices. 

Exhibit 20.  Offshore Performs Worse Than 1980s Correction
Offshore Performs Worse Than 1980s    Correction
Source:  Baker Hughes, PPHB

All the industry forecasts for global oil demand point to a strong need for more supplies in the future.  The offshore remains the most attractive area that has been the least explored on the planet.  Of course, the cost of offshore drilling and development today is much more expensive than in the past, but oil prices are certainly higher and they appear to be sustaining those higher prices.  The offshore drilling market seems to present an attractive opportunity for the oilfield service industry for expansion and increased profitability in the future.  Our only caution is the one we always make about all future energy markets – watch out for changes in oil/energy demand trends. 

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

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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