Musings From the Oil Patch – April 28, 2009

• Interior Secretary Shocks Coal Industry With Hot Wind
• Investors Starting To Favor Energy Stocks
• Soot: A Global Warming Issue; Only Discovered Now?
• The Potential For Energy Industry Takeover Activity
• EU Moves To Change Sustained Use of Energy
• Energy PE Firm Builds War Chest For Investments

Musings From the Oil Patch (Top)

April 28, 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

On April 6th, Interior Secretary Ken Salazar spoke in Atlantic City, New Jersey, at a summit meeting of 25x’25 America’s Energy Future, a group working to lower America’s carbon emissions.  During the meeting as reported by the media, Sec. Salazar said, “According to our report there is over 1,000 gigawatts (GW) of power, that’s a million megawatts (MW) of power that are developable off the Atlantic coast. You think about that, put it in the context of what it means, with respect to an analogy to, or a comparison to coal-fired power plants, it’s the equivalent of the amount of energy that would be produced from about 3,000 medium-sized coal-fired power plants. That’s a tremendous amount of energy that’s out there in the Atlantic.”  

He further went on to say, “More than three-fourths of the nation’s electricity demand comes from coastal states and the wind potential off the coasts of the lower 48 states actually exceeds our entire U.S. electricity demand.”  These two statements are very significant and were based on a report released by the Department of the Interior (DOI) in March.  A key conclusion of the report is that shallow-water offshore wind farms could supply as much as 20% of the electricity in most coastal states.  The report also concluded that the greatest offshore wind energy potential in the U.S. lies off the Atlantic Coast, which holds 1,000 GW of electricity, or one-quarter of the nation’s demand. 

In comments Sec. Salazar made to members of the media while off the podium, as reported by the Associated Press, he said, “The idea that wind energy has the potential to replace most of our coal-burning power today is a very real possibility. … It is not technology that is pie-in-the sky; it is here and now.”  Is that true, or is it hot air? 

According to the DOI report, there is actually the potential of 1,024 GW of wind power off the East Coast.  The DOI’s analysis relies on estimates provided by the National Renewable Energy Laboratory.  The report also says that there is the potential of 900 GW of power off the coasts of Washington, Oregon and California on the West Coast, but due to the deep water it is less likely to be developed.

With a theoretical potential of 1,024 GW of East Coast wind power, if the turbines ran at 100% of their rated power generation for 24 hours a day, they have the potential to produce 8.8 million GW of electricity, or more than twice the total amount of electricity generated throughout the entire United States.  Since wind doesn’t blow steadily all day, the DOI assumed only a 40% efficiency output for the wind turbines providing them the analytical support to conclude that this potential wind power could in theory replace all coal-fired along with most other sources of electricity in the country.

A key point about the DOI conclusion is that it believes there is only 253 GW of East Coast wind power in shallow water, or in water depths of less than 30 meters, or roughly 100 feet deep.  This means that three-quarters of the wind power potential the DOI believes exists is in water depths greater than 100-feet and that presents a technological challenge for exploiting it. 

At the present time there are proposals for about 2,000 MW of wind power off the East Coast with the Cape Wind project off Cape Cod the closest to development.  Cape Wind is planned to have 130 wind turbines with 454 MW of potential wind power, or nearly a quarter of the total proposed wind power capacity currently proposed offshore the East Coast.  Cape Wind is currently awaiting final approval of its environmental impact statement from the Interior Department and the overturning of an existing injunction for technical reasons from the Massachusetts energy regulatory body that should occur within the next 30 days.  Cape Wind executives have to be pleased with Sec. Salazar’s statements.

Given the “green agenda” of the Obama administration and the commencement of Congressional efforts to develop a national energy policy, wind will receive greater attention in the future.  Sec. Salazar has sparked a heightened interest in the potential development of wind power off the East Coast, but he has done it with some loose commentary that will have a hard time standing up to critical analysis.  The most successful offshore wind farms are off Denmark and Ireland.  Both countries have achieved significant gains in the use of wind power and other alternative fuels to reduce their carbon emissions.  Denmark’s success is well documented, but the progress and success of Ireland has received less attention.  The following exhibits show that success.

Exhibit 1.  Ireland Renewables Up But Fossil Fuels Dominant

Source:  SEI

Exhibit 2.  Ireland Wind Successful Among Renewable Fuels

Source:  SEI, Eirgrid

Exhibit 3.  Ireland Renewable Fuels Menu Expands and Grows

Source:  SEI, Eirgrid

As the true potential for wind power lies offshore in deepwater, no one has proven a design and installation technique to economically exploit this resource potential.  The industry still has to develop exactly how the electricity will be transmitted to shore, let alone develop the infrastructure to distribute it to customers.  Those issues aside, let’s look at what generating one million MW of electricity offshore might entail.

Exhibit 4.  Ireland Wind Power Installed Base Grows

Source:  SEI, Eirgrid

The capacity of wind turbines is wide, but the large wind turbines generally range between two and five MW.  Based on the turbines used by existing offshore wind farms in Europe and those in the approval process here in the U.S., the typical wind turbine will be 3.6 MW.  The typical wind turbine will have anywhere from 104-111 meter (330-355 feet) blade sweep.  To support these blades and to provide clearance above possible wave heights during storms, a wind tower will stand over 600-feet above the surface of the water.  How many of these wind turbines would be needed?

Exhibit 5.  Visual Pollution Will Hurt Wind Development

Source:  Nysted Wind Farm

We have seen several analyses of the required number of turbines needed to meet Sec. Salazar’s comment on generating one million MW.  One analysis suggested that with a 3.4 MW wind turbine, we would need 277,777 of them.  But that estimate is flawed because it assumes the wind turbine will operate 100% of the time (efficiency).  Wind data and experience confirms that the wind only blows part of the time.  Additionally, there will be periods of time when the wind is above the operational capability of the wind turbine, usually when wind speeds exceed 40 miles per hour. 

Another estimate was based on the operating model of the world’s highest producing offshore wind farm, Nysted Wind Farm offshore Denmark, which has 72 turbines with a total rated capacity of 165.6 MW (2.3 MW per turbine).  If the wind turbines can achieve 40% efficiency, then the output from a comparably-sized wind farm would be 66 MW.  To equal all the U.S. coal plant electricity output would necessitate constructing 3,540 similarly-sized wind farms, necessitating the installation of 254,880 wind turbines. 

Another estimate employed data based on Ireland’s experience with its offshore wind farms.  Their data suggests the wind turbines only generate 23% efficiency.  The analysis utilized 3.6 MW wind turbines that generate 0.8 MW output based on 23% efficiency, suggesting that the U.S. offshore effort would require 1.1 million wind turbines.  Yet another estimate says that the efficiency quotient would be 30%, meaning the project would only need 909,000 turbines. 

We used the Irish experience to modify the Danish-based example.  If you only get 23% efficiency rather than 40%, then the wind farm generates 38 MW instead of 66 MW.  That translates into 362,949 wind turbines necessary to generate one million MW of offshore power.  Obviously these estimates would be influenced by the efficiency of the wind turbines and their rated capacity.  If we consider 2-MW wind turbines, the estimated number is higher, but if they are 5-MW wind turbines, the required number would be lower.

Another consideration about the wind farms is how much of the coastline would they occupy?  The Cape Wind 130 wind turbine project is projected to occupy 25 square miles off Cape Cod.  A project proposed by Bluewater offshore Delaware calls for 200 turbines of roughly 3-MW each, occupying 30 square miles.  Both of these projects involve wind turbines at the lower end of the size range, so they are not as big as those at the upper end of the power generation range.  If the offshore wind farms go with the larger wind turbines requiring longer blades, each installation will need more space.  The wind farm analysis prepared based on the Nysted Wind Farm model indicates that there is a newly proposed wind farm called London Array that is projected to involve 1,000 MW with an estimated 400-MW output, or 40% efficiency.  These analysts estimate that to replace the electricity output of all the coal-fired power plants in the United States would take 569 similarly-sized farms.  Since the London Array will span 95 square miles, this means we would need to set aside 54,055 square miles of Atlantic coastal waters for wind farms. 

Some people had fun calculating that there wasn’t enough coastline to hold all the needed wind turbines if they were put side-by-side.  The Atlantic coastline extends for 2,400 miles, or 12,672,000 feet long.  Since the blade length of the suggested wind turbines is a maximum of 355 feet, and if we allow 50 feet of spacing between turbines, the entire coastline would only support 31,680 installations.  If we use the two estimates for required wind turbines based on the Nysted Wind Farm parameters, we would need rows of towers 8-11.5 deep spanning the entire length of the coast.  On the other hand, if we need 1.1 million wind turbines, then there would be forest of them extending 35 deep and stretching the entire length of the coastline.  That leaves no room for shipping lanes for entering and exiting our ports. 

With this many wind turbines stretching the entire length of the coastline, what happens when (not if) we get a hurricane that goes straight up the Atlantic Coast?  We have not seen any discussion about the performance of wind turbines in hurricane-type winds.  We know they usually shut down when winds exceed 40 mph, but what about possible damage to them from 100+ mph hurricane winds? 

The cost of this undertaking would be enormous.  Based on estimates of $3 million per MW of installed wind turbine capacity, the cost of a million units would be $3 trillion.  If we are only talking about 254,880 wind turbines, then the cost of the effort drops to only $765 billion, or nearly the size of the Obama stimulus plan.  Maybe this is how the Obama administration is planning to keep our economy growing at 3-4% a year in the future.

The spring survey of America’s money managers conducted by Barron’s finds that energy stocks are moving back into favor among investors.  In responding to the question to pick the best and worst performing industry sectors for the next 6-12 months, energy was ranked third in the best category and second to last in the worst. 

Exhibit 6.  Energy Coming Back Into Investor Favor

Source:  Barron’s, PPHB

One money manager was quoted as saying he expects to see oil prices climbing back to $100 a barrel as a worldwide economic recovery spurs inflation and the Federal Reserve attempts in coming months to mop up all the liquidity it has pumped into the financial system.  He characterized the challenge the Federal Reserve faces as “walking a tightrope,” and he doesn’t believe it has the dexterity to handle it. 

The investors surveyed are not particularly optimistic about the pace of the economic recovery – with 43% not expecting U.S. gross domestic product to turn positive before the fourth quarter and 50% not before 2010.  Despite that dour view, 60% of managers think stocks will be the best performing asset class in the next six to 12 months.  Some 23% of surveyed managers believe that commodities will be the top performing asset class.  That may well reflect their fears about inflation, which could lead to higher bond yields and rising prices not only for oil but gold.

In picking energy stocks to be among the best performers for the near future, money managers may be focusing on rotation within the stock market.  Energy stocks are down 7% in the past three months, underperforming the Standard & Poor’s 500 by 8% and leading many investors to question their fundamental outlook.  The energy underperformance has been most pronounced since the stock market rally began March 9th.  From that point, energy has underperformed by 12%.  This performance is not completely surprising given the challenge to company earnings from falling natural gas prices, stable crude oil prices and falling activity.  Many investors are wondering how long before oil and gas prices fall in response to record high inventories?  That potential has investors questioning how solid analyst earnings estimates for energy and oil service companies are in light of the potential for a further retrenchment in oilfield activity.  So far, reported company earnings have been slightly better than expected, but there are few signs that the bottom in earnings or oilfield activity has been reached.  The key issue is that investors need to own the stocks before the data confirms that a business turn has occurred, however after the recent run up in share prices, it is hard to push investors to keep buying energy stocks.

As the question of what the United States will do to address global warming, the issue of soot has suddenly been discovered.  The New York Times wrote a major article last week about soot, focusing on the mud cookstoves of Indians in Kohlua, India, about a two-hour bus ride away from Agra, the home of the Taj Mahal, where many of the residents work.  The cookstoves are fueled by twigs or dung and they emit dense clouds of smoke that leaves coats of black grime on the undersides of the thatched roofs and a brown cloud over the landscape. 

In Kohlua, there are virtually no cars and little electricity so emissions of carbon dioxide, the main heat-trapping gas linked to global warming are near zero.  But soot, also known as black carbon, is emerging as a major source of global climate change.  What we found amazing about the newspaper article was the writer’s continued reference to soot/black carbon being an unappreciated source of global climate change. 

The reporter actually wrote: “But the awareness of black carbon’s role in climate change has come so recently that it was not even mentioned as a warming agent in the 2007 summary report by the Intergovernmental Panel on Climate Change that pronounced the evidence for global warming to be “unequivocal.”  Mark Z. Jacobson, professor of environmental engineering at Stanford, said that the fact that black carbon was not included in international climate efforts was “bizarre,” but “partly reflects how new the idea is.”  The United Nations is trying to figure out how to include black carbon in climate change programs, as is the federal government.”

Before digging into the subject of soot and its impact on the visible evidence of global warming, we would offer two thoughts about the reporter’s observations.  First, if she had done any data research she would have uncovered numerous reports and studies about soot and its impact on global warming, which of course raises issues about the UN’s IPCC’s focus.  Were they truly concerned about addressing issues dealing with global warming/climate change, or were they motivated by some other agenda?  Second, the fact that Europe and the United States do not suffer from soot problems to the degree that underdeveloped and developing economies do means that there is little federal money here for research to solve a problem that has already been eliminated.  That seems to support the off-the record observations of people we have talked to about the global warming/climate change issue – it’s all about the money!

The New York Times writer was sent into the field to do research to back up the newspaper’s global warming coverage as part of a planned series of articles on the subject.  She ventured to India to visit with Dr. Veerabhadran Ramanathan, one of the world’s leading climate scientists who is a professor of climate science at the Scripps Institute of Oceanography.  He is currently in India working with the Energy and Resources Institute in New Delhi on a project to help poor families acquire new cookstoves.  He believes the planet is driving rapidly toward an environmental cliff.  Eliminating soot would be an easy step in addressing a cause of global warming while buying time for the world to mobilize and address the bigger issue of global warming/climate change – regulating the emissions of carbon dioxide. 

The principal source of black carbon in Asia and Africa is cookstoves fueled by wood, coal and dung, although black carbon also comes from the operation of diesel engines and coal-fired power plants there.  In the United States and Europe, black carbon from engines and power plants has largely been eliminated by the use of filters and scrubbers before the effluent is released into the atmosphere.  The impact of black carbon from cookstoves on Asia’s air quality is shown by the following computer generated maps based on data extrapolated from satellite pollution measurements collected by the Scripps Institute.

Exhibit 7.  Black Carbon Increases Pollution Emissions

Source:  Scripps Institute of Oceanography

While carbon dioxide is considered the leading factor in global warming, scientists are now recognizing that black carbon is the second most important factor.  Black carbon is estimated to be responsible for 18% of the planet’s warming compared to 40% for carbon dioxide.  Converting to low-soot cookstoves would remove the warming effects of black carbon quickly; shutting a coal powered electricity plant would take years to reduce the global carbon dioxide concentrations that are in the atmosphere. 

How significant is black carbon in the global warming/climate change picture?  One recent study estimated that black carbon might account for as much as half the Arctic warming.  What climate scientists are beginning to recognize is that while particles of soot tend to settle over time and do not have the global reach of greenhouse gases, they do travel.  Soot from India has been found in the Maldives and on the Tibetan Plateau; from the United States it travels to the Arctic.  The impact of soot emissions can be enormous.  According to Prof. Syed Iqbal Hasnain, a glacier specialist from the Indian state of Sikkim, Himalayan glaciers are expected to lose 75% of their ice by 2020.  These glaciers are a source of most of the major rivers in Asia.  The short-term impact of the melting ice is severe flooding in the mountain regions.  The number of floods from glacial lakes is already rising according to Prof. Hasnain.  After the glaciers shrink, Asia’s big rivers will run low or dry for part of the year and battles over water will likely add to the geopolitical conflicts in the region.

A major issue about black carbon and the population is its health impact.  Breathing the smoke from these biomass fires results in black carbon entering people’s lungs and damaging them and often causing death.  We know that as long ago as 1900, The Chicago Tribune published articles detailing the impact of black carbon on the lungs of citizens of that city.  In March, a bill was introduced in Congress that would require the Environmental Protection Agency to specifically regulate black carbon and direct aid to black carbon reduction projects overseas, including providing cookstoves to as many as 20 million homes.  The new stoves cost about $20 and use solar power or are more efficient when fueled with biomass.  The reduction in soot emissions from the new cookstoves is about 90%. 

Again we circle back to the revelation that soot is a new global warming/climate change phenomenon, at least from the reporter’s viewpoint and some of her climate scientist contacts.  After reading the report we dug through some of our old files and uncovered some articles about soot dating back to 2005.  We were very intrigued by one report that included pictures of a backyard demonstration of the impact of soot on snow.  While backyard snow is not the same as glacier ice, the demonstration makes the point clearly. 

The demonstration was conducted by Roger Pielke Sr., a well known and respected climatologist having held many high level climate and meteorological positions during his career and the author of over 300 research papers and nine books, who is currently semi-retired but remains a senior researcher at the Cooperative Institute for Research in Environmental Sciences (CIRES) at the University of Colorado in Boulder.  His information was presented on a weblog provided by Mike Smith, the CEO of WeatherData Services, Inc. an AccuWeather Company.

Dr. Pielke began by explaining the concept of “albedo,” which is defined as: The ratio of the outgoing solar radiation reflected by an object to the incoming solar radiation incident upon it.”  Fresh, pure white snow has an albedo of nearly 100%.  In other words, just about all of the solar energy striking the snow is reflected back into space.  Since the heat is reflected rather than absorbed, the solar energy has relatively little melting effect on pure white surfaces.  It is why people where white clothes more frequently during the summer and in tropical climates in an attempt to remain cool.

If the ‘color’ of the snow is darkened by soot, the albedo drops dramatically.  The soot absorbs some of the radiation that otherwise would have been reflected, thus heat is transferred from the soot into the snow resulting in an acceleration in the rate of melting. 

Importantly, the heat transfer can cause melting to increase even if the ambient temperature remains constant, i.e., why snow can melt even in sub-zero temperatures.

Exhibit 8.  Fresh Snow With Ash Cover

Source:  Roger Pielke

Dr. Pielke tossed some eight month-old fireplace ash on fresh snow in his backyard one December day when the sky was totally blue.  The demonstration occurred two days after the winter solstice when the albedo effect is less than it would have been under clear skies in February or March.  In just one hour, the greater melting of the ash-covered areas becomes readily apparent.

Exhibit 9.  Fresh Snow And Ash-Covered Area: One Hour Later

Source:  Roger Pielke

After four hours, the ash-free area has a depth of 5.5 inches.

Exhibit 10.  Ash-free Area Four Hours Later

Source:  Roger Pielke

At the same time, the ash-covered areas have a depth of about 2.5 inches.

Exhibit 11.  Ash-covered Area Four Hours Later

Source:  Roger Pielke

The areas without soot melt about 0.5 inches of snow in the four-hour period while the soot-covered areas melt 3.5 inches.  Dr. Pielke suggests that any discussion about melting glaciers must consider the accelerated melting caused by soot pollution in addition to any contribution from changing ambient temperatures.  The problem is that correcting soot pollution, which could have a very significant impact on the world’s glaciers, doesn’t feed global warming/climate change scientists’ families.

At a recent meeting of the Houston chapter of the National Association of Corporate Directors (NACD), one of the speakers on a panel dealing with enterprise risk issues to be considered by corporate directors highlighted energy industry takeovers as a possible emerging risk.  William Gutermuth from the Houston office of Bracewell & Giuliani LLP discussed unfriendly takeovers as an enterprise risk and the role of poison pill defensive plans.  Changes in attitudes toward poison pills in recent years coupled with the dramatic decline in energy company share prices during the past 12 months presents an environment that is ripe for a possible increase in the number of unfriendly takeover attempts in this industry.

Poison pills are essentially plans, generally approved by shareholders, which lay out a pre-determined course of defensive action against an unwanted takeover attempt that is triggered by a hostile offer.  Most plans involve the sale to existing shareholders of additional shares at a nominal value designed to significantly increasing the cost of a hostile takeover for the acquirer.  The hostile acquirer is confronted with having to buy a substantially greater number of shares than he originally anticipated in his bid, presumably increasing the acquisition cost to a point he may consider abandoning the effort.  The plans have various time periods of restrictions against the hostile acquirer moving forward and when the additional shares may be issued.  The ultimate purpose of the poison pill is to provide the board of directors with a period of time to hire legal and financial advisors and to begin an orderly defense against the hostile bid, while also providing time for other suitors, or possibly “white knights,” to get involved in the bidding process. 

In recent years, poison pills have fallen into disrepute.  The idea being that from a good governance viewpoint, having poison pill plans in place discourages possible acquisition approaches to the detriment of shareholders and possibly to the enhancement of directors and management.  The belief is that if an unfriendly takeover offer is received, poison pill plans can still be put into place and activated with sufficient time to prevent a steamrolling by the acquirer of the board of directors, whose obligation is to ensure that if the company is sold it is to the highest offer.  As a result, there has been a trend in recent years to allow existing poison pills to expire.  Mr. Gutermuth presented data showing that in 2007 and 2008, 60% and 71%, respectively, of poison pill plans scheduled to expire were allowed to naturally end. 

After presenting this information, Mr. Gutermuth presented data designed to highlight the possible enterprise risk that directors need to consider as part of their obligation for overseeing the governance of their companies.  Between 2004 and 2008, data from SharkRepellent.com shows that there has been roughly a tripling in the number of unsolicited/hostile takeover transactions and an equally large increase in the number of proxy fights. 

Exhibit 12.  Hostile Takeover Action Is Climbing

Source:  Bracewell & Giuliani

According to the FactSet MergerMetrics report for 2008, unfriendly transactions represented 23% of all announced deals involving full acquisitions of U.S. public companies.  This was well above the percentage of unfriendly deals witnessed in the past five years where 2006 saw the next highest percentage of just 14%. 

Exhibit 13.  Top Quartile Can Buy Any Other Company

Source:  Bracewell & Giuliani, PPHB

What Mr. Gutermuth then showed was a chart based on his office’s examination of 10-Q corporate filings with the Securities and Exchange Commission for the period ending September 30, 2008, showing the average market capitalization of the top 250 U.S. based exploration and production and oil field service companies and their cash balances and available credit lines divided into quartiles.  The amazing point is that the average cash and available credit total for the top quartile companies exceeded the average market capitalization of all the companies in the three remaining quartiles.  It is also important to note, the top quartile cash and available credit total was determined after excluding the huge cash hoards of ExxonMobil, ConocoPhillips and Chevron.  In fairness, today, given the recent rally in stock prices and the drop in revenues and profits for energy companies, their financial resources have probably shrunk.  The credit crisis has resulted in many company lines of credit being reduced or cancelled.  As a result of the changed business environment, this analysis is likely not completely valid.  But the point is that the U.S. energy industry is under significant stress and many valuable companies potentially are at risk of being purchased in a hostile takeover.  So what should directors do?

According to Mr. Gutermuth, there are four points that need to be considered to make sure that a company is not swooped up on the cheap in a hostile takeover.  Even though share prices for energy companies are well off their 2008 highs, a fully-financed cash offer at a premium to the current market price has to be considered by the board.  It cannot fall back on the “Just Say No Defense” anymore since according to Mr. Gutermuth, the courts will not respect that defense.  He also said that when confronted with a hostile takeover attempt, boards are entitled to consider a range of alternative actions beyond merely the sale of the corporation.  They may also demonstrate how a corporate strategy can reasonably be expected to create a higher value than that received in the takeover attempt.  A way to provide the directors with the opportunity to evaluate the alternatives is to have a shareholder rights plan (poison pill) in place.  This would insure that the board can control the evaluation and sale process.  Mr. Gutermuth’s last point was that the process should be controlled by the independent directors on the board along with professional advisors.  

Sharkrepellent.net reported that in 2008 there was a late-year surge in poison pill adoptions.  The 28 poison pill adoptions in December were the most in any month since October 2001.  There were 127 total adoptions in 2008, the most in any year since 2002 shortly after the tech-stock collapse.  The 76 first-time poison pill adoptions in 2008 was the most in three years, a dramatic reversal from 2007’s total of only 42, which was the lowest total since the early 1980s.  It would appear that the stock market fall and the rise in hostile takeover attempts is motivating companies to adopt poison pill defenses.

The European Union is instituting an energy efficiency strategy that, if successful, could produce a sustained reduction in demand for energy.  The plan calls for enacting policies to curb the consumption of gas and electricity.  The possible success of the strategy has been assessed in a recent report by Cambridge Energy Research Associates (CERA) entitled Strategies for a Leaner Europe: Meeting the Energy Efficiency Challenge.  According to CERA’s assessment, if the EU can meet its goal of cutting energy usage by 20% by 2020, there would be a fundamental reshaping of Europe’s energy marketplace by 2030.

The EU has put together a strategy to cut emissions by increasing the use of renewable fuels along with curtailing the growth in energy demand by improved efficiency of buildings, vehicles and appliances.  One aspect of the plan is the banning of incandescent light bulbs by 2012 and the mandatory use of compact fluorescent lamp (CFL) bulbs.  Another area of EU focus is on improving the efficiency of condensing boilers, which are in use in 50% of the homes in the Netherlands but used much less elsewhere in Europe.  The biggest problem for cutting electricity demand is the spread of gadgets such as MP3 players and personal computers, but energy savings can come from strategies such as mandating less wasteful standby modes on electronic gadgets.  These standby modes are one reason why electricity demand has continued to grow in spite of significant efficiency gains in electronic products since consumers have become accustomed to the “instant-on” feature of TVs, for example. 

Exhibit 14.  Potential Electricity Efficiency Savings

Source:  Financial Times, PPHB

While the EU needs to legislate the new standards, the organization’s Parliament has moved forward with steps mandating higher efficiency standards for new and remodeled buildings along with higher standards for various appliances.  Other appliance efficiency standards are being implemented, also.  If the EU can achieve its goal of a 20% energy savings by 2020, it will significantly reduce its dependence on Russian natural gas supplies that are scheduled to rise in the future as Europe’s local gas supplies decline.  It would also reduce the need for constructing new pipelines and LNG importing terminals. 

The CERA study believes that the EU will be able to cut its gas consumption and stop electricity consumption from growing while using only the technology available today.  By 2030, EU gas consumption could be back to the levels of the early 1990s, or about 125 billion cubic meters a year below today.  That savings is about equal to the combined natural gas consumption of Germany, France and Spain.  Achieving these energy savings will come at a cost, estimated by CERA at about 250 billion Euros ($332 billion). 

CERA’s more realistic view is that if the EU institutes mandatory efficiency savings and adheres to its renewable fuels initiative, even with an economic recovery and higher energy prices starting in 2010, total natural gas consumption across the EU could drop 16% by 2020 and 35% by 2030 over 2008 levels.  As CERA’s Doug Howe pointed out, electricity demand would remain flat under this scenario.  He went on to say, “That means overall energy – electricity and gas – would sustainably decline in this scenario.  This would be unprecedented in the history of Europe.  Eye-opening as these results are, even these would not meet the 2020 goal on energy efficiency set out by the Commission, but fall short by nearly half.”

One new electricity efficiency effort underway in parts of Europe is the roll-out of “smart” meters that measure and can help regulate the consumption of electricity.  There have been very few studies of the amount of electricity that can be saved by the use of these meters and their embrace by consumers as a way of altering consumption patterns.  According to Mr. Howe, the results of the few small studies that have been competed are all over the map, so it is virtually impossible to predict consumption savings with any degree of accuracy.  He believes there will be savings, but the addition of these meters could also inflate CERA’s cost estimate by 40-60 billion Euros ($53-$80 billion).  

A sustained reduction in energy consumption in the EU is a strategic goal with a number of beneficial results.  First, it would reduce the region’s geopolitical tensions with its major gas supplier – Russia.  Second, it would eliminate the need for significant investment in new energy infrastructure.  Third, it would help to achieve the emissions reductions targets the EU has established for its global warming initiative.  While all laudable goals, energy consumption savings are already on the horizon under a do-nothing strategy since the demographics of Europe dictate a smaller population and an older population, both of which assure less energy consumption.  Not a lot of people have focused on how the aging population in Europe will alter many of the region’s current economic, energy and emissions conditions.

First Reserve Corp., the largest private equity investor in the energy industry recently announced it has closed a $9 billion buyout fund, the twelfth fund in the 26-year history of the firm.  William Macaulay, co-founder and CEO of First Reserve, commented in an interview with the Financial Times that the fund raising effort was one of the longest and toughest money gathering undertakings in the company’s history, lasting almost a year.  The effort, however, fell short of the original goal of raising $12 billion, but given the night-and-day changes in the energy, private equity and investment worlds, it is not surprising First Reserve could only raise 75% of its target despite an outstanding long-term performance record. 

We suspect that without this outstanding investment track record, First Reserve would have had a greater challenge to raise as much money as it did, and quite possibly impossible to do.  According to data disclosed by California State Teachers Retirement Systems (Calstrs), First Reserve generated a 50% internal rate of return on its $2.3 billion Fund X, which closed in 2004.  Calstrs has also reported that the last six funds, which include Fund X, generated average net returns of about 25% a year.  With this investment performance, it is not surprising that Calstrs invested $800 million, while the Washington State Investment Board committed $400 million and the California Public Employees’ Retirement System put up $300 million.

The success of First Reserve in raising $9 billion is in contrast to the overall private equity business.  Investors put less money into private equity funds in the first quarter of 2009 than they have done for almost six years.  According to French private equity fund tracker, Prequin, the industry raised only $46 billion in 2009’s first quarter, down from $125 billion in 2008’s fourth quarter.  The first quarter investment was the lowest quarterly total since the $34 billion raised in the fourth quarter of 2003.  “Two-thirds of investors are sitting on the sidelines and most are selling, not buying,” said Antoine Dréan, chief executive of Triago, which advises private equity groups on fund-raising.

The First Reserve Fund XII’s $9 billion total exceeds the $7.8 billion fund it raised in 2006.  The earlier fund made several high-profile oilfield service company buyouts last year – the $3 billion purchase of Canadian-based CHC Helicopter Corp., the largest provider of flights to offshore drilling rigs and platforms around the world, and the Scotland-based Abbot Group PLC, a large international contract driller providing both land and offshore drilling rigs, purchased for $1.8 billion.  The CHC deal was the largest oilfield service buyout in 2008 while Abbot was the largest land driller deal of the year.  Because of the high values paid for these companies, which were already trading at premium valuations before the deals were

announced, 2008 generated a record average valuation for oilfield service M&A transactions.

Exhibit 15.  Valuations of PE and Oilfield Service M&A Activity

Source:  Dealogic, PPHB

Mr. Macaulay indicated that First Reserve has recently lowered its five-year oil price forecast from $60-$80 a barrel to $50-$70.  But with oil prices having fallen from $147 last year to around $50 now, he suggested he would be investing more in oil reserves in the near future.  He also is reportedly targeting energy equipment manufacturing businesses and uranium reserves as attractive investment areas.  At the present time, First Reserve has a number of oil and gas exploration and production investment efforts, so there is always the opportunity to leverage off these existing enterprises with money to help fund projects requiring greater investment than the existing companies can supply. 

First Reserve has been very active in virtually every type of energy – oil and gas, coal, solar, nuclear, wind, landfill gas and ethanol.  It has invested in infrastructure opportunities such as the largest storage terminal facility in the Caribbean, power generation facilities, pipelines and terminal facilities and even refineries.  They have also invested in energy insurance and collateralized loan obligations for energy companies.  They also have a start-up venture seeking investment opportunities in shipping.

More recently as global energy projects have become larger and the funds necessary to make them financially viable, First Reserve has begun teaming up with strategic industry investors such as Halliburton (HAL-NYSE), Schlumberger (SLB-NYSE) and Nabors Industries (NBR-NYSE).  These arrangements have allowed First Reserve to participate in creating ventures that meet the operational needs of its strategic partner who does not necessarily have to put up money but can contribute operating assets and/or new business ventures while providing solid investment returns to the investment fund.  These strategic relationships will most likely become more important in the future according to Mr. Macaulay who is quoted in the Financial Times as saying, “The opportunity set is really pretty good in the energy business so, contrary to what you might think, we are actually working on how to make the $9 billion last long enough, such as by teaming up with more strategic partners.”  Clearly, First Reserve and its partners plan on helping reshape the global energy industry, which is probably entering a significant transformational period.

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.