Musings from the Oil Patch – May 26, 2009

• Observations From Our Trip To The North
• Climate Change Debate Highlighted By Business Summit
• Chinese Auto Sales The Driver Of Energy Demand Growth
• Shrinking Europe Gas Market Could Impact US Gas Market
• Barron’s And Fortune Rankings of Energy Companies
• NOAA Hurricane Forecast Consistent With CSU Projections

Musings From the Oil Patch
May 26, 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

Setting out on our annual drive to our summer home in Charlestown, Rhode Island, a week ago Friday, we were curious about what we would learn about the state of the U.S. economy.  We found that much like the economic statistics being released daily that show a mixed bag for the health of the economy, our observations seemed to have the same characteristic.  Knowing that we faced a 1,900-mile journey, we were somewhat anxious to get on the road as quickly as possible after the Friday morning rush hour.  Unfortunately, several errands delayed our departure until shortly before 11 a.m. 

One of those errands brought us up close to the new technology of ATM machines.  Our local branch of BankAmerica (BAC-NYSE) has just installed one of the latest ATM machines and positioned a teller outside in a lawn chair to help guide patrons through the machine’s use.  This machine no longer requires that you place your deposit inside an envelope before inserting it into the machine.  BAC has already done away with the need to fill out a deposit slip to accompany a check deposit.  When we approached the ATM the clerk asked if we were making a deposit.  Since we were, she showed us how to put it into the special slot and voilà an image of the check appeared on the ATM screen with a request to verify it.  Once deposited, I was able to ask for receipt with or without a copy of the check.  So now I have visual proof of my check deposits even though I have never had a problem with BAC over a deposit, but it does give one greater peace of mind.  As a side note, the local BAC branch in Rhode Island says they are getting these new ATM machines in about a month.

Our trip north this year has to have been the worst we have experienced in the 12 years we have been making the drive.  The reasons for the difficulty were traffic (!) and weather.  We head east and don’t turn north until we reach Slidell, Louisiana, so we drive the I-10 and I-12 highways then head north on I-59.  This year I-10 seemed to be stop-and-go all the way to Baton Rouge, Louisiana, and I-12 to Slidell wasn’t much better.  It took us two hours longer to drive the Gulf Coast stretch of the trip than in past years. 

We were warned about slowdowns by construction signs, but none were evident, not even men standing around leaning on shovels.  We also ran into situations where everyone on our side of the highway had to “rubber-neck” to look at police and emergency crews responding to accidents on the other side.  What struck us most about the traffic, which was much heavier than we expected for a recessionary economy, was the bunching up of trucks.  Truck companies have installed governors on the engines of the tractors to prevent drivers from going too fast and cutting into fuel efficiency.  That was a much bigger issue last year with pump prices in the $4+ per gallon range.  What we found was that lower fuel prices make some truck drivers want to drive faster, so they are always trying to pass other, slower trucks but don’t have the sufficient power/speed to overtake them.  This means that you get several trucks blocking the highway as the faster one tries to pass.  This happened a number of times causing faster vehicles to have to slow down and wait for the truck to complete his pass.

The weather slowdown hit us in Virginia Saturday evening when, after having driven through showers and rainstorms off-and-on in Alabama and Tennessee, we were hit with a typical Gulf Coast “gully-washer” characterized by white-outs when you can barely see the road.  Driving in those conditions through the middle part of Virginia’s Shenandoah Valley in the dark was lots of fun.  We always marvel at how much better some people must be able to see the road and the hazards ahead as they roar pass us at 75-85 miles per hour, well over the 65-mph speed limit on dry roads.  That storm added to our travel time on day two, but fortunately not too severely.

What we did conclude about the trip was the amazingly few recreational vehicles and fifth-wheelers we saw.  We kept a rough count of the large RVs and estimated that we saw only about 50 of them on the entire 1,900-mile drive.  This was quite amazing since we are at the point in the year when retirees are making their migratory trips from south to north and many people are starting off on early summer vacations or heading to graduation ceremonies.

The lack of RVs was in contrast to the heavy truck traffic we experienced on I-10.  A thought crossed our mind that the traffic was heavier than anticipated due to it being a Friday, but then we have almost always made part of our drive on a Friday, but usually not the I-10 leg.  Once we turned north on I-59, however, the truck traffic fell off noticeably.  In fact, it was probably the least amount of truck traffic we have ever encountered.  The lightness of the truck traffic was evident by the absence of trucks at the official state weighing stations and at the rest areas and truck stops.  Within the mix of I-10 trucks, we saw more carrying parts for wind turbines heading west than goods and equipment for drilling heading east.  Is this a sign of the Obama energy plan at work, we wondered?

We also found that there was no problem getting hotel rooms on this trip.  Because of past experiences when we could not secure a room in the city we wanted, we made a point of calling ahead earlier in the evening and making a reservation.  Upon arrival, we found that none of the hotels were anywhere close to being full, and the prices we paid were extremely reasonable – in fact downright cheap!  We stopped at two Cracker Barrel restaurants for dinner; the one in Slidell had no waiting line at 7 p.m. while the other in Roanoke, Virginia, had a 10-minute wait at 7:30 p.m.  (At the latter Cracker Barrel we noticed a large number of locals patrons based on the familiar greetings by the staff.)  Our wait times were nowhere near as long as we waited in prior years.  Based on these observations, we have to agree with a recent newspaper article saying that people were staying home rather than going away for vacations.  In fact, The Providence Journal article had an accompanying story highlighting all the local things to do if you stayed home for vacation – a crucial consideration for the direction of crude oil prices.  Based on what we observed, we remain skeptical of the optimistic scenario calling for an upturn in vacation driving for this summer, especially with pump prices rising sharply in recent weeks.  Our view may be colored by us being firmly ensconced in the middle of an economic depression region otherwise known as Rhode Island.

On gasoline pump prices, we found them not materially higher than those we left behind in Houston.  In the course of the trip, we purchased premium grade gasoline that ranged between a low of $2.329 a gallon (Harrisonburg, Virginia) and a high of $2.699 (Danbury, Connecticut).  Our fill-up in Houston, just as we were preparing to leave, cost us $2.459 per gallon.  While the weekend USA Today reported that gasoline pump prices had jumped by $0.25 a gallon for regular in the prior week, it also pointed out that compared to last year the price was $1.63 a gallon lower.  We expect that as long as gasoline prices remain below $3.00 a gallon for regular fuel, driving will not be seriously curtailed.  That does not take into account the impact of other economic problems like increased joblessness, housing foreclosures and financial stress.

Another thought that struck us on the drive was how little highway construction we experienced.  Was it because of the economic plight of the various states we traversed or was it because they had no plans to be doing anymore improvements on the roads we travel?  We did determine that Pennsylvania roads (primarily I-84) are now our top-ranked roughest roads, taking that honor from Louisiana.  There still remains a very short stretch of I-59 that goes through the edge of Georgia that is pretty rough, but the state has been slowly rebuilding small stretches, although no new sections were being rebuilt when we passed through. 

There is a stretch of U.S. Route 1 in Rhode Island that is very rough, largely reflecting the terrible financial condition of the state.  So it was with great interest that we saw in the local paper an article saying federal stimulus money had been secured to repave this stretch.  While the politicians were all taking bows over getting the money, we found it interesting that it would be another 4-7 weeks before they would be able to start the project.  Wonderful planning – the road construction will take place during the height of the summer beach traffic on probably the busiest stretch of road at that time of the year in South County, Rhode Island – so much for “shovel-ready” construction projects.  The total cost of the repaving will be $3 million and it will be spent some 6-7 months after the passage of the stimulus bill that was passed in January to pump up the economy in a hurry. 

On the Saturday morning of our drive, as we sat eating breakfast, we were scanning the weekend edition of USA Today and saw an article about automobile dealerships.  The story was highlighting the fate of two brothers, both Chrysler dealers in Jackson, Mississippi.  One, the top Dodge dealer in the state for the past several years, received a letter telling him that he was being terminated.  Next door, his brother, a Chrysler/Jeep dealer, was told he was being retained.  The article pointed out that Chrysler was shutting down nearly 800 dealers while GM (GM-NYSE) was possibly about to sever ties with over 1,000 dealers.  The article got us thinking about the unintended consequences of these dealership closings.  While the lost jobs are most evident, we thought about the Little League teams without sponsors and the reduced civic charity donations plus the increased effort car owners will undergo to get their vehicles serviced, let alone the impact on highway billboard owners.  These were only a few of the thoughts that crossed our mind.

The last observation from the trip was an encounter we had with the gentleman manning the counter at the Best Western motel in Meridian, Mississippi, where we spent Friday night.  He was an elderly, gray-haired black man, impeccably dressed in a black suit, a black dress shirt and a black and white patterned tie.  After we passed back our signed credit card receipt he studied it for a long time.  We wondered if we had signed in the wrong place or something.  But then he turned and said, “Your handwriting looks just like that of the man down at the bank.  He said his came from signing his signature so many times.”  We didn’t say anything, but thought about his comment.  Yes, we sign our name a lot – checks, credit card receipts, hotel registers, shareholder proxies, etc.  Maybe our signature looks as it does because of the number of times we sign it.  Then we thought, maybe that gentleman doesn’t have to sign his name very often so his signature is much easier to read.  Maybe less is better!

This past weekend the World Business Summit on Climate Change was held in Copenhagen, Denmark, organized by the Copenhagen Climate Council.  This meeting is another in the series of global climate meetings leading up to the December meeting in Copenhagen at which the successor treaty to the Kyoto Protocol is to be negotiated by the leading nations of the world.  Former Vice President Al Gore is the keynote speaker at the conference.  At the same time, the U.S. House of Representatives will put the finishing touches on its version of climate change legislation.  The House bill was passed last Thursday and now awaits action by the Senate on its climate and energy policy legislation.  The House legislation, named the Waxman-Markey Bill, includes a detailed “cap and trade” scheme that has been undergoing extensive modifications in an attempt to horse-trade to secure the necessary votes to get the legislation passed.  From a bill with few emission credits being given away and most auctioned off, the ratio has flipped dramatically in the other direction.  Now, 85% of the credits will be awarded free with the balance auctioned off.

While all of this is going on, we were reading the detailed letter from The Viscount Monckton of Brenchley to Representatives Ed Markey (D-MA) and Joe Barton (R-TX), the majority and minority leaders of the House Committee on Energy and Commerce about the misinformation about the global warming and climate change science and statistics that is behind this legislation.  UK’s Lord Christopher Monckton, the former science advisor to UK Prime Minister Margaret Thatcher, testified before the Committee on March 26th and his letter was to provide additional follow-up evidence and support for the three graphs used during his testimony.  In addition, he was later asked by Rep. Barton to provide the Committee with justification and verification of his assertion that the cumulative frequency, intensity and duration of all hurricanes, typhoons and tropical cyclones is currently less than at any time in the 30-year satellite record.  Lastly, Lord Monckton decided to add information in response to issues raised by various members of the Committee during the day’s hearing, often to correct or explain the answers of his fellow panelist.

The more amusing aspect of the report, and Lord Monckton’s report on the 35 Inconvenient Truths – The Errors In Al Gore’s Movie, was the effort by the Committee later to prevent him from testifying at the same hearing when the Committee was to hear from Al Gore.  Climate Depot reported in its April 23rd issue that Lord Monckton’s appearance at the hearing was rejected by the Democratic members of the Committee when it was announced he was to be the Republican witness along with Mr. Gore. 

As the story was reported, House Democrats had told Republican committee staff earlier that they would have an unnamed “celebrity” witness for the multi-panel climate hearing examining the House energy bill.  When it was revealed that the “celebrity” witness would be Mr. Gore, the Republicans announced they too would have a “celebrity” witness.  Rep. Barton asked Lord Monckton to appear.  When his plane landed in Washington the day before the hearing, he was informed that the Democrats had refused to allow him to testify alongside Mr. Gore.  The Republicans were forced to call in former Speaker of the House, Newt Gingrich, to testify.

This episode is not surprising since we have seen many situations in which Mr. Gore refused to debate critics of his global warming stance.  Mr. Gore’s antipathy toward Lord Monckton probably dates back to the High Court in London’s identification of nine “errors” in Mr. Gore’s award-winning movie, An Inconvenient Truth.  Lord Monckton played a role in the case.  The judge stated that if the UK Government had not agreed to send to every secondary school in England a corrected guidance note making clear the mainstream scientific position on these nine “errors,” he would have made a finding that the Government’s distribution of the film and the first draft of the guidance note earlier in 2007 to all English secondary schools had been an unlawful contravention of an Act of Parliament prohibiting the political indoctrination of children.  Each of the nine “errors” identified by the judge has been admitted by the UK Government to be inconsistent with the mainstream of scientific opinion.

We found Lord Monckton’s letter to the Committee and the data contained in it quite illuminating.  He showed how the UN’s International Panel on Climate Change (IPCC), the U.S. National Climatic Data Center (NCDC) and NASA’s Goddard Institute of Space Studies (GISS) data had been altered to help build the case for global warming, which was supposedly accelerating and necessitated immediate and drastic remedial action.  At the time Lord Monckton testified in March, he was appearing alongside Tom Karl, the Director of the NCDC, which is responsible for much of the temperature data used in the global warming argument.  Based on the text of the letter there were numerous times when Mr. Karl failed to answer the questions of Committee members, even about the data produced by his organization, NCDC. 

Lord Monckton presented the following chart showing that there has been a decline in global temperatures since 2002 based upon the government’s own data.  This was one of the charts that generated the most agitation among the Committee members and Mr. Karl.  Lord Monckton showed in the graph that we have experienced seven years of global cooling at a rate of 3.5°F per century rate, which is the equivalent of a 2°C rate.  This data is in direct contradiction of the IPCC forecast for warming at a 5.3°C rate per century. 

Exhibit 1.  Global Cooling Temperature Chart Used At Hearing

Source:  Monckton letter, Committee on Energy and Commerce, March 30, 2009

One of the questions Mr. Karl equivocated in answering was whether global temperatures had been falling for the past seven years.  As the data from the NCDC data base shows, the downward trend is quite obvious. 

Exhibit 2.  Global Cooling Trend Based Only On NCDC Data

Source:  Monckton letter, Committee on Energy and Commerce, March 30, 2009

Lord Monckton also demonstrated that the cooling trend conclusion was supported by all four of the primary temperature databases utilized in climate research in the United States.  All of these data bases have been employed to support the IPCC case for global warming. 

Exhibit 3.  Four Major Temperature Data Bases Confirm Cooling

Source:  Monckton letter, Committee on Energy and Commerce, March 30, 2009

Lord Monckton further showed how temperature data sets had been changed over time following adjustments to the data undertaken by the GISS.  He raised the question of whether these changes should be investigated to determine why the raw data was altered, and especially why older series displayed was changed in ways that support the thesis of global warming.

Exhibit 4.  Santa Rosa Data Shows Impact of GISS Adjustment

Source:  Monckton letter, Committee on Energy and Commerce, March 30, 2009

While Lord Monckton stated that he has not had time to investigate the reason why the GISS data has been altered, he pointed to the dramatic difference between the 1999 and 2008 data sets to demonstrate why researchers distrust this particular data set.  We know the Goddard temperature data has been altered and the action has been admitted to by the chief administrator, James Hansen.  Mr. Hansen has been the leading U.S. government official behind the global warming movement.  He has publicly stated, “Global warming skepticism can confuse the public.”

Exhibit 5.  GISS Data Base Was Even Altered Last Year

Source:  Monckton letter, Committee on Energy and Commerce, March 30, 2009

Lord Monckton showed in the letter that the IPCC presented a chart in its 1990 report showing the Medieval warm period that miraculously disappeared in the 2001 version of the committee’s report.  The elimination of this historic warm period, well acknowledged and accepted by scientists and historians, was done using statistical techniques based on a paper published in Nature magazine and authored by Michael Mann, Raymond Bradley and Malcolm Hughes, the authors of the article containing the infamous “hockey-stick” temperature graph that has since been discredited by both earth scientists and statisticians.  Lord Monckton pointed out that the “new” temperature chart was reproduced six times, in full color, and at large scale in the 2001 IPCC report, the only chart so treated.  He ascribes the repeated use of that chart to political rather than scientific motives.

Exhibit 6.  Medieval Warm Period Acknowledged By IPCC

Source:  Monckton letter, Committee on Energy and Commerce, March 30, 2009

Exhibit 7.  IPCC Rules Medieval Warm Period Out Of The Data

Source:  Monckton letter, Committee on Energy and Commerce, March 30, 2009

Shortly before the start of the World Business Summit, China published a document on the web site of its National Development and Reform Committee, suggesting that developed nations should cut greenhouse gas (GHG) emissions by 40% by 2020 from 1990 levels.  This is at the high end of a suggested range of emission cuts that emerged from the 2007 Bali meeting, which developed a roadmap for dealing with global warming.  No official figure for cutting GHG emissions was established at the time. 

The United States has proposed reducing its GHG emissions by 17% by 2020 from 2005’s level, while Europe has said it will cut its emissions by 20%, however, it is prepared to increase the reduction to 30% if other countries agree.  China, along with India, remains suspicious of the impact significant mandated GHG emission cuts will have on its economic growth and efforts to improve living standards for its citizens.  China also asked for the rich countries (not identified) to donate between 0.5% and 1.0% of their annual gross domestic product to poorer countries to deal with climate change.

The China Daily newspaper reported that Chinese researchers have concluded the country will have to invest an extra one trillion Yuan ($146 billion) each year or 40 trillion Yuan by 2050, to achieve living standards comparable to those of the West while developing a relatively low carbon emissions economy.  It is hard to believe that China will embrace such a plan since the government’s primary focus remains on developing jobs to employ the maximum number of workers in the country and reduce any potential political unrest.  It was evident from China’s proposal that it is feeling pressure from the rest of the nations of the world to become more engaged in efforts to control GHG emissions prior to the year-end meeting, and to become an active supporter of GHG emission controls to be negotiated at the Copenhagen conference.

All of this came at the same time the United States reported a reduction in its GHG emissions for 2008 based on preliminary data.  The 2.8% reduction in GHG emissions, according to the U.S. Government was due to reduced transportation emissions from less driving because of high fuel prices and lower economic activity.

Exhibit 8.  2008 GHG Emissions Down

Source:  EIA

The importance of the various U.S. economic sectors for controlling GHG emissions is highlighted by the chart in Exhibit 9.  The electric power and transportation sectors are the principle sources of GHG, but they are also the ones that have already undertaken significant steps to reduce their GHG emissions.  The Obama Administration’s new rules for increasing the average fuel efficiency of the automobile fleet and improving their tailpipe emissions are targeted at lowering GHG emissions.  Solving this challenge may prove much more difficult than either the government or the auto industry is willing to admit.  The average car produces a lot less carbon dioxide than it did in the mid 1990s, but not much less than in the middle part of this decade.  Making cars cleaner may prove much more costly since the easy gains have already been achieved.

Last year, Germany’s environment agency estimated that a 20% reduction in tailpipe emissions would cost about €1,000 ($1,400) per vehicle.  But a 40% reduction would add €5,000 ($7,000) to the purchase price, possibly pricing cars out of the range of many consumers.  The other way to achieve a cleaner auto fleet is to stuff it full of small cars rather than SUVs or even large sedans.  So while President Obama says he doesn’t want to be running the domestic automobile industry, he is laying the groundwork for dictating exactly

Exhibit 9.  Power And Transportation Are Primary GHG Sectors

Source:  Agora Financial

Exhibit 10.  Only Commercial Showed GHG Increase

Source:  EIA

what kinds of cars Americans will be able to buy in the future.

The challenge the country faces is the fact that the Obama Administration and the Democrat-led Congress claim that they have put “junk science” (presumably practiced by the Bush Administration) behind us.  Instead, they have embraced global warming science that may be anything but science as Lord Monckton, along with a host of other climate scientists, has demonstrated.  Mish Michaels, a weather forecaster working at Boston’s WBZ station, wrote on his blog after attending an M.I.T. clean energy forum in early April, “…there was no discussion of climate science.  The globe is warming and humans are to blame – all that is taken as truth.  But is it all really so certain?”  He went on to discuss the role of climate change in the history of Boston where in times in the past it has been considerably warmer than now and at other times, buried under a mile-thick layer of ice.

Mr. Michaels wrote, “We [weather forecasters] are able to model the atmosphere using mathematical equations of motion and thermodynamics.  This enables us to forecast and although we are far from perfect, we do pretty well out to 7 days.  Weather forecasting can be viewed as one of the greatest human achievements of our time.  But if you ask me about this summer – I really don’t know.  Hotter than average?  A wet July?  Even the best weather minds in the government and private sector recognize that seasonal forecasting is business that pretty much eludes us.”

We are about to embark on a significant restructuring of our economy based on science about global warming that is not allowed to be fully scrutinized and investigated.  We are confident in our weather forecasts out for a week, but not for a few months, yet we are about to restructure our global economy based on a forecast out for 100 years.  The entire discussion about unintended consequences from economic policy actions based on this science has not even begun, and most likely will never be held because it gets in the way of action.  As Lord Monckton suggested, the correct action to address a non-problem is to have the courage to do nothing.  Unfortunately, politicians are loathing sitting still since they believe they are being paid by their constituents to do something – even bad things!  If only politicians were required to take the Hippocratic Oath – First, do no harm.

The global petroleum industry is counting on the emergence of a large middle class in China as its savior for flagging oil demand.  A key characteristic of the middle class is expected to be automobile ownership.  At the present time, China’s automobile sales account for approximately 7% of the country’s gross domestic product (GDP).  The Chinese government has recently altered its subsidy and taxation policies toward automobiles – increasing subsidies for new purchases while lowering taxes on cars with smaller engines and doubling them for large-engine vehicles.  The Chinese government is actively using its tax policy to both boost its domestic economy while trying to rein in its carbon emissions. 

A Chinese think-tank run by the Sinopec Group issued a report last weekend suggesting that growth in automobile purchases would help drive the country’s demand for oil.  Mao Jiaxing, vice president at Sinopec’s institute for economic and technology research, was quoted as saying, “The growth in Chinese automobile ownership has just begun, which will boost future petroleum demand.”  With Chinese car ownership at 37.7 vehicles per 1,000 people, the country’s automobile population is just beginning to grow.

The institute report says that China’s oil demand should rise from 380 million tons (7.8 million barrels per day (b/d)) in 2008 to 410-420 million tons (8.4-8.6 million b/d) by 2010.  It sees the country’s demand rising further to between 500-530 million tons a year (10.3-10.9 million b/d) by 2015.  In 2020, the institute foresees demand reaching 570-620 million tons a year (11.7-12.7 million b/d).   China’s oil demand growth will be between 4.2% and 5.0% a year during the 2010 to 2015 period.  That growth rate will slow to between 2.3% to 3.5% a year during the 2016 to 2020 period.

Exhibit 11.  China Auto Sales Will Drive Oil Needs

Source:  U.S. Global Investors

With Chinese automaker inventories at a three-year low, there is plenty of room for the government to stimulate sales, which will help the domestic economy to recover from the global recession.  China’s consumption of gasoline, diesel and kerosene in 2008 was 210 million tons, or 4.3 million b/d.  That figure is expected to grow to 220 million tons (4.5 million b/d) by 2010, and then increase to 300 million tons (6.2 million b/d) by 2015 and 400 million tons (8.2 million b/d) by 2020.  The significance of the growth in the automobile fleet is that the percentage of total consumption demand represented by transportation-related oil is forecast by the Sinopec institute to rise from 55% in 2008 to 58% in 2015 and to 67% in 2020, measured against the midpoint of the range of overall oil demand predicted. 

One aspect of this forecast that we do not know is how it accounted for the potential impact from electric cars.  China has stated that it intends to become the global leader in electric cars, which presumably would start with its own vehicle fleet.  In December, China’ BYD Company Ltd. (BYDDY-PK) introduced its F3DM model, the first mass-produced plug-in hybrid vehicle.  BYD plans to begin manufacturing a version of this vehicle in Europe in 2010 and in the United States in 2011.  In a recent study, PricewaterhouseCoopers estimates that hybrid vehicles share of global new vehicle sales could grow from 0.7% currently to 3.7% in 2015.  If China does embrace electric vehicles, one has to question whether future oil demand might be lower than Sinopec currently is projecting.

Implicit in the Sinopec forecast would appear to be a prediction of a less-than-robust global economic recovery in the coming years.  Why do we believe this?  Recent Chinese government statistics have sent mixed signals about the health and pace of the country’s economic recovery.  Economic growth appears to be underway, yet the country’s electricity consumption has fallen in recent months.  The explanation appears to be the huge manufacturing overcapacity built for export booms.  Energy-intensive industries account for about 42% of China’s electric power consumption, yet they contribute only about 11% to the country’s GDP.  Weak performance of these industries will have a disproportionately greater impact on electricity statistics than on overall economic performance. 

Exhibit 12.  Overcapacity A Long-term Challenge

Source:  U.S. Global Investors

If transportation fuel’s share of total petroleum consumption grows by almost 22% between the recessionary year of 2008 and a presumably healthy economic year in 2020, one has to assume that the more energy intensive sectors of China’s economy will not grow anywhere near as strongly as the domestic auto sector.  To us it would suggest that the Sinopec institute forecasters are anticipating a Chinese economy that is going to have a different flavor and focus than it has experienced during the past decade.  A more domestically-focused and less manufacturing-oriented Chinese economy would imply fewer exports.  The question is would that curtailment of export volumes be in response to a weaker global economy or a designed policy to promote domestic market expansion over international trade?  We are not sure that the Chinese government would want to sacrifice international markets for more domestic business.  That suggests a sluggish global economic recovery – not necessarily a good thing for the global oil industry despite the growth in Chinese oil needs.

New forecasts for European natural gas demand are calling into question the role Russian natural gas will play in the continent’s supply mix.  Long-term, the European gas market outlook has implications for the U.S. gas market.  IHS Global Insight says it expects European gas demand to fall by almost 10% this year, which will pressure Russian gas suppliers hoping to capture a larger share of the continental market.  The problems last winter over the delivery of Russian gas to Eastern Europe that resulted in thousands of people shivering in their homes prompted a recent meeting between EU and Russian officials to attempt to resolve the gas delivery issue permanently.  However, based on media reports, Russian President Dmitry Medvedev refused to grant assurances to EU consumers that future gas supply cutoffs might not happen again.  In fact, he said he doubted that transit state, Ukraine, through which the gas flows, had enough money to pay for the gas Russia supplies, suggesting that future disruptions are likely.

The bigger problem for Russia, however, is the prospect of falling gas demand in Europe coupled with surging global liquefied natural gas (LNG) supplies and Europe’s desire to insulate itself from winter fuel disruptions.  According to Bernard Reutersberg, CEO of E.ON Ruhrgas AG (EO-N-AS), “The days of high growth rates for European gas consumption are surely over.”  This is bad news for OAO Gazprom (OGZPY-RK), the Russian gas export monopoly.  Gazprom is Russia’s largest company and its export revenues account for about a tenth of the country’s gross domestic product.  Last year Gazprom boasted of boosting its share of the European gas market to 33% by 2015 from its current 25% stake.  With a falling gas consumption outlook and increased gas competition, that boast could prove hollow. 

Gazprom prices its long-term gas supply contracts off a basket of oil products, but with a six-to-nine month lag.  Therefore, it is looking for a near-term boost to its gas sales from customers who have been holding off buying until prices fell.  What Gazprom risks, however, is increased pressure from its long-term customers to renegotiate these agreements to reflect the currently emerging more competitive gas market.  Additional pressure will come from the proposed EU

Exhibit 13.  Europe Gas Demand To Fall

Source:  The Wall Street Journal

targets to reduce greenhouse gas emissions by 20% by 2020, and efforts to get 20% of the EU’s energy demand sourced from renewables such as solar and wind power. 

Whether the EU environmental and/or energy efficiency targets are capable of being realized remains in doubt, however, there exists a distinct possibility that mandatory goals will be implemented.  Should that happen, and oil prices rise, natural gas consumption will suffer.  IHS Cambridge Energy Research Associates says the combination of these conditions could lead to a 16% drop in EU natural gas consumption by 2020 and a 35% decline by 2030.  This dire outlook was echoed by Mr. Reutersberg who said that if the environmental goals are met and oil prices hit $100 a barrel in 2010, European gas use in 2020 would be 22% lower than today and import needs would be 5% lower.  That could drive increased LNG supplies to the United States putting downward pressure on domestic gas prices.

Barron’s newspaper recently released its 2009 Barron’s 500 company rankings that had a reasonable representation of energy companies.  At about the same time, Fortune magazine published its rankings of the top 500 companies.  The two rankings are based on different measures of financial performance.  The sharp reversal of fortunes for energy commodities and the stock market during the second half of 2008 had contributed to energy companies not ranking as highly for the latest year, but still demonstrating better performance over longer time frames.

Barron’s ratings are prepared by HOLT, a unit of Credit Suisse (CS-NYSE), and employ three equally weighted measures to grade and rank the largest companies by sales in the U.S. and Canada that trade on U.S. stock exchanges.  For each company, HOLT calculates the median return on investment based upon cash flow for the past three years, using a proprietary cash-flow-return metric called CFROI that strips out the effects of inflation and adjusts for accounting distortions.  HOLT also calculates CFROI in the latest fiscal year compared with the three-year median, sales growth in the latest fiscal year, adjusted for acquisitions and divestitures.  Each company is graded in the three categories.  The top quintile in each gets an A, the bottom an F.  HOLT then calculates a total grade-point average, or GPA, for each company, with 4.0 being the highest.  Ties are broken using CFROI in the latest fiscal year compared to the three-year median.  In recognition of the current economic environment, this year’s Barron’s 500 ranking excludes companies operating in bankruptcy and those effectively nationalized by the U.S. government.

In the 2009 Barron’s 500, there were 37 companies that are oilfield service, exploration and production, international oil companies or refiners.  We found another 36 companies that are engineering companies that do a lot work in the energy industry, master limited partnerships of largely energy midstream businesses or gas utilities.  Collectively, these 73 companies represent about 15% of the 500 companies ranked in the Barron’s survey.

The table below shows the 37 companies we elected to focus on as most reflective of the energy sector.  Interestingly, there were three companies with 4.00 GPAs compared to four last year.  Of this year’s top-ranked companies, two were ranked in the top group last year with one new company this year –- Cameron International (CAM-NYSE). 

It was quite interesting to see how companies in both the 2009 and 2008 surveys moved within the rankings.  Five companies were listed in the 2009 survey that did not appear in the 2008 survey.  Equally interesting was that 18 companies in this year’s survey ranked lower than they did last year, while 16 companies were ranked higher.  The most dramatic change may have been for McDermott International (MDR-NYSE) that went from 10th place in 2008 to 268 this year.  That performance reflected the dramatic change in the health of the offshore construction and power markets experienced by McDermott. 

Overall, the energy companies performed well, mostly ranking in the upper half of the 500-company universe.  In fact, only nine companies were in the lower half of the survey.  There were no energy companies falling into the bottom quartile of the survey universe, again reflecting the strong industry environment experienced over the past three years, despite the second half of

2008 collapse.  Given the deteriorating energy industry fundamentals and the weaker current financial performance of companies, it will be interesting to see how many and where energy companies rank in the 2010 survey.

Exhibit 14.  Barron’s 500 Rankings Show Energy Performs Well

Source:  Barron’s, May 11, 2009, PPHB

The Fortune magazine rankings focuses on the largest companies in the United States based on various measures.  At the time the survey was published, much was made about ExxonMobil (XOM-NYSE) reclaiming the top spot based on market value.  There were only two energy companies in the top 20 ranking by market value with Chevron (CVX-NYSE) joining XOM.  When ranked by equity, those two energy companies were joined by ConocoPhillips (COP-NYSE).  No energy company was in the top 20 based on number of employees, not surprising given the nature of the energy business.  When companies were ranked by other measures of revenues, the participation of energy companies declined.  There was only one energy company in each of the categories: revenues per dollar of assets and revenues per dollar of equity.  There were, however, nine energy companies in the revenues per employee category.

In terms of growth in profits and revenues, energy companies demonstrated the impact of the second half of 2008 collapse of its business.  For example, there were three companies ranked in the top 20 measured on growth in profits for one year, but there were four for the five-year measure and five companies in the 10-year period.  Likewise, there were four companies in the top 20 in growth in revenues for one year; six for the five-year measure; and eight in the ten-year period.  The impact of the 2008 energy and stock market was most noticeable in the total return to shareholders measure where there were no energy companies in the one-year measure; seven in the five-year period; and six in the ten-year listing.  Four of the companies in the ten-year ranking also were in the top 20 companies for the five-year ranking.

The sharp reversal of fortune for energy last year and continuing this year, and likely next, will impact how energy companies fare in the rankings next year.  While it is impossible to predict now, we would expect there may be one-third to a half the number of ranked companies in the 2010 survey.  However, just as the energy fundamentals reversed quickly last year, they could just as easily shift back into a bullish scenario later in 2009 or in 2010.  The future of energy will depend on the health of the global economy and how consumers fare financially over the next six to 12 months not only in the OECD countries but in the developing economies of the world, also.  Once again the fortunes of the energy business will depend on demand growth with growing crude oil and natural gas supply challenges playing a key supporting role.

Last week the U.S. Government’s National Oceanic and Atmospheric Administration (NOAA) issued its first forecast for the upcoming storm season suggesting a “near-normal” Atlantic hurricane season.  In NOAA’s press release announcing its forecast, the agency put a 50% probability for a “near-normal” season, a 25% probability for an “above-normal” season and a 25% probability for a “below-normal” season.  NOAA uses probabilities and ranges in its forecast.  They estimate a 70% chance that there will be nine to 14 named storms this season with four to seven becoming hurricanes and three of them major hurricanes (Category 3, 4 or 5).

The NOAA forecast is pretty much in line with the slightly reduced April forecast issued by the hurricane forecasting team at Colorado State University.  Their April 7th forecast called for 12 named storms with six hurricanes and two intense hurricanes.  Recently, when Dr. William Gray of CSU was interviewed about the upcoming storm season, he suggested that there was a good probability that his group would be further reducing its projected number of storms.  While CSU and NOAA are expecting average storm activity for this storm season, both caution that it only takes one storm targeting U.S. landfall to create severe economic, financial and safety issues.  NOAA’s press release urged American citizens living along the U.S. coastline to take precautions for the upcoming season and make preparations for possible storm landfalls.

Both CSU and NOAA have talked about the various atmospheric and ocean conditions that influence the upcoming hurricane season.  There are forces that have a positive influence on the formation of storms while others tend to diminish them.  According to NOAA, the strongest positive factor influencing storm formation is the multi-decadal signal, which creates warm Western Atlantic water, West African rainfall and reduced wind shear.  On the other hand, a possible El Niño in the Pacific Ocean that produces warmer and stormier Eastern Pacific Ocean conditions could help increase Atlantic wind shear that often weakens hurricanes or prevents them from forming.  Additionally, it is possibly there will be cooler Eastern Atlantic water that also tends to impede the formation of hurricanes. 

Exhibit 15.  Various Climate Factors Impact Storm Formation

Source:  NOAA

Based on these early forecasts, it looks like 2009 will be a less active tropical storm season than those experienced throughout most of this decade.  That would be a welcome condition, and it could help the offshore oil industry sustain Gulf of Mexico production and help tame any sharp upward move in commodity prices.  For many oil and gas companies, and energy investors, this scenario may be something of a depressant since they are probably relishing the possibility of spiking oil and gas prices to help boost energy company profitability and stock prices.

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 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.